Thoughts From The Frontline : GDP

If This Is Recovery…

John Mauldin — Sat, 14 Nov 2009 05:31:00 GMT

If This is Recovery, Where Are the Taxes?
Last Business Standing
Stimulus, What Stimulus?
The Reality of Unemployment
Let the Good Times Roll
The Quick Double-Dip Scenario
Phoenix, New York, and Thoughts on the Internet

No one goes into Wal-Mart and asks to pay extra sales tax. Thus sales taxes are reasonable barometers for retail sales. This week we look at how taxes are doing in a period of economic recovery. Then we turn our eyes to a very interesting (and sobering) analysis of possible future unemployment rates. This is an anecdote to the happy-face analysis of employment numbers you get from establishment economists. There will be a lot of charts and tables, so this letter may print a little longer, but I think you will find it very interesting.

If This is Recovery, Where Are the Taxes?

I keep reading about surveys that show that retail sales are up. But as noted above, no one pays extra sales taxes, or decides they need to pay more income taxes. The surest way to measure retail sales is sales taxes. Want to know how incomes are doing? Look at income tax receipts. Let's look at sales taxes first.

First off, I can find no single source of recent sales tax information. It is all one-off, but it is consistent. Sales taxes in my home state of Texas are down 12.8% year-over-year, and we're in the fifth straight month of decreases of 11% or more. Projections are for sales taxes to continue to decline into 2010.

There is a very revealing study by the Pew Center on state taxes, called "Beyond California" (http://www.pewcenteronthestates.org/). Everyone knows how bad California is. The Pew Center looks at how the rest of the states are doing, and focuses on 10 states that also have severe problems. Sales tax receipts are down 14% in Arizona, and state income taxes are down 32%.

On average, revenues are down almost 12%. Oregon has seen their revenues collapse a stunning 19%. New York is down 17%, with a deficit of 32%. Illinois has a projected deficit of 47% of its budget, second only to California with 49%. You can see how your state fares at http://downloads.pewcenteronthestates.org/Beyond_California_Appendix.pdf.

The Liscio Report notes that all states had negative year-over-year sales tax collections in October, and the weighted average decrease was 10.2%, down from a negative 7.2% in September. (www.theliscioreport.com)

Sales at Wal-Mart stores slipped by 0.4% in the third quarter. Actual government figures show that retail sales were down 1.5% in September from the previous month and 5.8% year-over-year. So how do we keep seeing headlines about retail sales being up, as unemployment keeps rising?

Remember that such reports are usually based on surveys, and generally cover mid-sized and up retailers, leaving out smaller businesses. Further, if you are a retail chain that has closed 10% of its stores, the remaining stores should in theory benefit from getting your loyal customers into them.

Last Business Standing

Yesterday I was with an associate, and I hesitated in asking them how their business was doing, because I knew things had been tough at the beginning of the year. But I did ask, and they said sales were up over the last months and business was looking better. Surprised, I asked them what made the difference. "Ah," they said, "less competition. Our competitors have gone out of business."

Best Buy and other electronic retailers had to benefit from Circuit City disappearing. That is Schumpeter's creative destruction at work. Not very good for total employment, but it does help the profitability of the survivors.

So, if things are so bad, how did we have 3.5% growth in the third quarter? First off, things are not as bad as they were in the past year. We are in fact getting close to an economic bottom, at least for now. Second, the 3.5% number is a preliminary estimate. A study by Goldman Sachs suggests that the number will be revised down by at least 0.5% and maybe as much as 1%.

Why? The estimate does not really take into account how poorly small businesses are performing. If you look at small-business indexes and compare them to historical GDP numbers, you get the smaller number mentioned above. And since at least 2% of the GDP was from the stimulus package (Cash for Clunkers, houses, tax cuts), the economy on its own was flat. That begs the question, what happens when the stimulus runs out?

And the answer is that we won't know for some time, as the stimulus is just getting ramped up. "According to CBO estimates, only 21% of [the stimulus] spending will occur in 2009; another 38% will come in 2010, and 22% in 2011. After that, its effect will dissipate quickly." (The Liscio Report)

But David Rosenberg notes that what the federal government is giving, the states are taking away. The Pew Study shows that at least nine other states are in appalling shape, so it is no wonder that David writes:

Stimulus, What Stimulus?

"Fully nine states are in fiscal distress and only two have balanced budgets. States like Michigan are planning 20% budget cuts for the coming year. Indiana is planning a 10% spending cut in light of a 7.4% YoY revenue decline. How can the economy really be out of recession if government revenues are still deflating?

"The states are filling around 40% of their fiscal gaps with the federal stimulus (so much for spending on "shovel ready" infrastructure projects). Even after the fiscal help from Washington, the state governments will still face a projected deficit of $142 billion for 2011 (versus $113 billion in 2010). All in, the restraint in the state and local government sector is estimated to drain a full percentage point from U.S. GDP growth in 2010 and more than fully offset the stimulative efforts from Washington. The U.S. economy is more likely to post growth of little more than 2% next year, rather than the 5% currently being discounted by the equity market."

The Reality of Unemployment

All this is, of course, going to put continued pressure on employment. As I noted last week, the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey, not the 190,000 you read about in the mainstream media. Unemployment is sadly continuing to rise by significant amounts.

In August, I did an interview with CNBC from Leen's Fishing Lodge in Maine. The unemployment numbers had just come out. I did a back-of-the-napkin estimate that we would need about 15 million new jobs over the next five years just to get back to where we were when the recession started.

That works out to a need for about 125,000 new jobs each month to handle new workers coming into the market (which comes to a total of 7.5 million over five years), plus the 8 million and rising jobs we've lost. That is a daunting number. It amounts to 250,000 new jobs a month every month for five years. And we are still losing more than that number a month, let alone adding the needed 250,000.

Look at the chart below. It shows the establishment survey employment figures for the last ten years. Only once, in 1999, did we actually add over 250,000 jobs a month for a whole year. And that was during the internet boom.

Sadly, the private sector has shed over 300,000 jobs since 1999. Think about that. We have had a decade where there have been no new jobs added by the private sector. Real incomes are roughly where they were, and the stock market is down. Talk about a lost decade.

I love it when someone does the really heavy lifting for me, and my friend Mike Shedlock of Sitka Pacific Capital Management has done a wonderful job of taking that speculation of mine and putting it into a spreadsheet that helps us get a real handle on what unemployment is likely to look like for the next ten years. I am going to make use of his basic analysis and then modify some of his assumptions in the spreadsheet he provided me, in order to think about different scenarios.

All three scenarios are based on assumptions, so let's see what Mish started with. There is a wealth of data available from the Bureau of Labor Statistics and the Census Bureau. According to the Census Bureau Population Estimates we are going to add about 2.5 million working-age (16 years old and up) citizens a year, from now until 2020. The numbers varies slightly year to year. Mish used an estimate of the average, summing up the buckets from 16 to 100+ for the years in question and rounding the result.

You can go to the BLS site and look at Table A-1, which shows the civilian noninstitutional population (those over 16 not in prisons), the participation rate (those who are working and/or want to work), the unemployment rate, the number employed, those not in the labor force, and those who want a job. Those are starting numbers for the charts below.

For those interested, you can read Mish's very full (and quite detailed) analysis at his blog site http://globaleconomicanalysis.blogspot.com/2009/11/mish-unemployment-projections-through.html). But let's look at his assumptions:

Job losses are likely to continue for a minimum of another year.
When job gains start, they will be very slow at first, then pick up.
An extremely generous monthly job gain stat over the course of the year would be 150,000 jobs.
A falling participation rate (boomers retiring) will continue to mask reported unemployment.
Starting in 2013 the labor pool will start decreasing because of Boomer demographics.
The noninstitutional population will rise by 2.5 million workers a year.

The spreadsheet below needs a little explanation. Let's start with the assumptions. Mike starts with current working-age population and adds 2.5 million people a year. He assumes that Boomers will retire at 65 (something which all the surveys say is not going to happen). And his last estimate is what the unemployment numbers will be. Everything else is based on those assumptions, which leads to the first column, or the expected unemployment number.

By the way, we know that everyone will want to make different assumptions. I am going to create three scenarios, but you can go to Mike's blog and at the bottom of the post is a link to the actual spreadsheet. Have fun. Let's look at scenario 1.

This assumes there is no double-dip recession, and jobs roughly rise along the same lines as the last recovery. Actually, Mish is far more optimistic, as in the very first chart you will notice that job losses were negative in the first year after the end of the recession and flat the second year. Mish has jobs rising by 120,000 next year and 600,000 the second year (2011), and then a fairly robust recovery. Below is the graph of the unemployment numbers under such a scenario.

Notice that unemployment stays at or above 11% for three years. Pessimistic? Mainstream and usually very optimistic Mark Zandi of www.economy.com predicted this week that unemployment would rise to 11% by the middle of next year, right in line with this scenario. Also note that total jobs rise by 14 million over ten years. Hardly doom and gloom. Again, Boomers all retire on time and there is no double-dip recession.

Let the Good Times Roll

What would it take to get back to 5% unemployment? I played with the spreadsheet and came up with the following numbers, which get us below 5% by 2020. I assume no recessions for the next ten years, and 2 million new jobs a year after 2011, which I start off with almost 1.5 million jobs. Of course, we have never done that, but let's be optimistic.

And the graph below shows the unemployment numbers for the Good Times Scenario.

Want to get to 5% within five years? Add 3 million jobs a year starting now. With no housing recovery, a smaller auto industry, and financial firms getting leaner.

The Quick Double-Dip Scenario

When I called the last two recessions about a year before they happened, it was not all that hard. We had inverted yield curves, falling leading indicators, and a lot of other data that pretty much pointed to a recession. Believing that we had a housing bubble and a looming credit crisis also helped my conviction in calling the last recession.

I think we are in for a double-dip recession in 2011, yet I readily admit there will be little if any statistical evidence in advance this time. This is more of an instinct call. I have serious doubts that we can have what amounts to the largest tax increase of all time in what will be a very weak (albeit growing) economy, without putting us back into recession. And Speaker Pelosi thinks it is a smart thing to add another 5.4% surtax on what will already be a rising capital gains and dividend tax.

Taxing small businesses, and that is what the tax increase amounts to, is a very bad idea in a weak economy. Small businesses are where the job growth comes from. Taking money from productive businesses and giving it to government is a fundamentally flawed concept.

Now, if they decide to postpone the tax increase, or phase it in slowly, then maybe we avoid the double dip. But right now it doesn't look like that will be the case. So, let's quickly see what a double-dip scenario might look like. Let's be optimistic and assume we only lose another 1.2 million jobs in the next recession, since we have already lost so many in this one (8 million and counting). And then the economy comes roaring back in 2012 with 1.5 million jobs and continues to grow rather smartly for the rest of the decade. No further recession. We absorb the tax increases and move on with our economic lives.

Unemployment under such a scenario would rise to just under 13% and stay above 10% for 8 years. Take a look at the chart and graph.

Think 13% is too dire? This week David Rosenberg said unemployment would rise to between 12-13%. The former Merrill Lynch economist was one of the few mainstream economists who called the recession and the credit crisis. The so-called "Blue Chip" economists told us at the beginning of 2008 that unemployment would peak out at 6%. While Rosie is not optimistic of late, he has a rather solid record of being right.

We are at 10.2% unemployment today. The economy lost jobs for 21 months after the end of the last recession. That would easily take us into 2011. Another million lost jobs will take us well over 11% and close to 12% (remember, you have to add in the increasing population), even without my double-dip scenario.

The letter is getting long and it's getting late, so let me close with a few thoughts.

First, 12% unemployment is horrendous by American standards. But Spain is now at 20%, and much of Europe has been in the 10% range for years.

Second, Americans are not used to the concept of 12% unemployment or 10% rates for extended periods. That is going to cause a serious backlash across the political spectrum. Couple that with the discomfort over $1.5-trillion deficits and there could be some serious political changes in the coming years. I think the message will be more anti-incumbent than one party or the other.

Third, the only way out of this morass is to create an environment where small business can thrive. As I've noted for the last several weeks in this letter, government spending does not increase GDP over time. It is a temporary nonproductive stimulus. It takes private investment to create jobs and increase productivity. Over the next few months, I will write more about how to do that.

Phoenix, New York, and Thoughts on the Internet

Next week I take a quick one-day trip to Phoenix, then back to do a satellite-remote speech to a South African hedge fund conference. I will be in New York the first weekend of December (the 4th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org). Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there.

The 7 kids, spouses, and grandkids are starting to gather. We will all have brunch Sunday and then a shower for Tiffani. She has another 6 weeks before she is due, and she is really uncomfortable. Walking is literally a pain.

Permit me to reminisce. A little over 9 years ago I started this letter on the internet with about 2,000 email addresses. It was a new version of what had been a print letter, as that was the business I knew. The internet was still a new thing to me, but it seemed like a good idea at the time. Little did I know.

I am still amazed at the growth and the direction my business and life have taken. My letters are sent out by various publishers and affiliates to over 1.5 million readers and posted on dozens of web sites, and the numbers have been growing rapidly of late. I am grateful. But I wonder what would happen if I started it today. Ten years ago there was little in the way of free economic letters. Not a lot of competition.

Today, there is so much free information that it's staggering. There have to be thousands of blogs and hundreds of free letters, some with very large circulations. It seems a new star is born every few months. While much of it does not add to the level of conversation, some of it is quite excellent. I think I am lucky to have started when I did.

And I am grateful for the kind attention you give me. As I turn 60, I note that this has been a rather overwhelming last ten years. A lot of changes for me, and almost all of them very good. But there are more to come. The last two flights I was on I was connected to the internet at 35,000 feet. I sense a lot more changes coming. I am thinking a lot about how to keep up and not get left behind, how to make sure that you, gentle reader, continue to get my best. That is what, at the end of the day, drives me.

Have a great week. I know I shall. Dad loves it when his kids (from 15 to 32) and spouses and grandkids are all under one roof.

Your amazed at it all analyst,

John Mauldin

The Glide Path Option

John Mauldin — Sat, 07 Nov 2009 04:54:00 GMT

The Present Contains All Possible Futures
The Ugly Unemployment Numbers
Argentinian Disease
The Austrian Solution
The Eastern European Solution
Japanese Disease
The Glide Path Option
Philadelphia, Orlando, and Phoenix

The present contains all possible futures. But not all futures are good ones. Some can be quite cruel. The one we actually get is dictated by the choices we make. For the last few months I have been addressing the choices in front of us, economically speaking. Today I am going to summarize them, and maybe we can look for some signposts that will tell us which path we're headed down. For those who are new readers and who would like a more in-depth analysis, you can go to the archives at www.investorsinsight.com and search for terms I am writing about. And I will start out by briefly touching on today's ugly unemployment numbers, with data you did not get in the mainstream media.

But first, let me welcome the readers of EQUITIES Magazine to this letter. The publisher is sending the letter to you directly. This letter is free, and all you have to do to continue receiving it is type in your email address at www.investorsinsight.com. Likewise, I have arranged for my regular readers to get a free subscription to EQUITIES Magazine, if you would like. You can go to www.equitiesmagazine.com. For those who don't know, I write a brief monthly column for them.

The Ugly Unemployment Numbers

The headlines said unemployment, as measured by the "establishment survey," was down by 190,000; and even though that was slightly worse than forecast, market bulls were cheered by the fact that the number was not as bad as last month's. It is an improvement that we are not falling as fast.

Well, maybe. What I did not see in many of the stories I read was that the number of unemployed actually soared by 558,000, to 15.7 million, as measured by the household survey. The establishment survey polls larger businesses; the household survey actually calls individual households.

Let's look at the real number in the establishment survey. If you don't seasonally adjust the number, the actual change in unemployment for October was 641,000, or about 450,000 more than the seasonally adjusted number. And the Bureau of Labor Statistics added 86,000 jobs that they simply guess were created through the so-called birth-death ratio. Interestingly, the birth-death ratio number is not seasonally adjusted, so it is just added to the unemployment number. http://www.bls.gov/web/cesbd.htm

The total (U-6) employment rate is at a record high of 17.5% (this includes those who are part-time for economic reasons). There are now over 10.5 million people who have lost their jobs since the beginning of the downturn.

My favorite slicer and dicer of data, Greg Weldon (www.weldononline.com), offers up an even more horrific number. As I have noted before, if you have not looked for work in the last four weeks, the BLS does not count you as unemployed. Quoting Greg:

"Moreover, when we combine the monthly change in the number of Unemployed, with the number Not in the Labor Force, we might consider the result to be a proxy for the actual 'change' in the underlying labor market situation ... in which case, October's figure of 817,000 represents the fourth LARGEST yet, behind last month's (September's) second largest figure of 1,021,000 ... for a two-month combined figure of 1.838 million, in newly Unemployed, or no longer 'in' the Labor Force ...

"... the second LARGEST two-month total EVER posted, barely trailing the December-08/January-09 total 1.955 million.

"Bottom line ... basis this measure AND the 'Total Unemployment Rate,' we could conclude that not only is there NO 'improvement' in the labor market, but moreover, that it continues to DETERIORATE, intently."

There are plenty more implications in the data, but let's turn to the topic of the day.

The Present Contains All Possible Futures

Like teenagers, we as a US polity have made a number of bad choices over the past decade. We allowed banks to overleverage and, in the case of AIG (and others), sell what were essentially naked call options of credit default swaps, based on their firm balance sheets, far in excess of their net worth; and that put our entire financial system at risk. We gave mortgages to people who could not pay them, and did so in such large amounts that we again brought down the entire world financial system to the point that only with staggering amounts of taxpayer money was it brought back from the brink of Armageddon. We assumed that home prices were not in a bubble but were a permanent fixture of ever-rising value, and we borrowed against our homes to finance what seemed like the perfect lifestyle. We did not regulate the mortgage markets. We ran large and growing government deficits. We did not save enough. We allowed rating agencies to degrade their ratings to a point where they no longer meant anything. The list is much longer, but you get the idea.

Now, we are faced with a continuing crisis and the aftermath of multiple bubbles bursting. We are left with a massive government deficit and growing public debt, record unemployment, and consumers who are desperately trying to repair their balance sheets.

If present trends are left unchecked, we will need to find $15 trillion in the next ten years, just to pay for US government debt, let alone state, county, and city debt. And perhaps some loans for business will be needed? Where can all this money come from? The answer is that it can't be found. Long before we get to 2019 there will be an upheaval in the market, forcing what could be unpleasant changes.

We are left with no good choices, only bad ones. We have created a situation that is going to cause a lot of pain. It is not a question of pain or no pain, it is just when and how we decide (or are forced) to take it. There are no easy paths, but some bad choices are less bad than others. So, let's review some of the choices we can make. (Again, I am being very general here. You can go to the archives for more specifics. This is a summary letter.)

Argentinian Disease

One way to deal with the deficit is to do what Argentina and other countries have done: simply print the money needed to cover the deficits. Of course, that eventually means hyperinflation and the collapse of the currency and all debt. There are writers who think this is an inevitable outcome. How else, they ask, can we deal with the debt? Where is the political willpower?

One large hedge-fund manager in Brazil humorously remarked that Argentina is a binomial country. When faced with two choices (hence binomial) they always made the bad choice. Could it happen here?

Hyperinflation is not an economic event; it is a political choice. I think last Tuesday's election is a sign that the voter population is beginning to pay attention to the need for something more than talk of change. There is growing discomfort with the size of the deficits. Further, the Fed would have to cooperate in order for there to be hyperinflation, and I think there is only a very slight (as in almost zero) chance of that happening. Could Congress change the rules and take over the Fed? Anything's possible, but I seriously doubt there is any appetite in saner Democratic circles for such a thing to happen.

I think the chances of hyperinflation in the US are quite low. It would be the worst of all possible bad choices.

The Austrian Solution

Here I refer to the Austrian school of economic theory, based on the work of Ludwig von Mises and Friedrich Hayek, et al. There are those in the Austrian camp who argue the need to do away with the Fed, return to the gold standard, allow the banks that are now deemed too big to fail to go ahead and fail, along with any businesses that are also mismanaged (such as GM and Chrysler), and leave the high ground to new and more properly run.

In their model, government spending is slashed to the bone, as are (in most cases) taxes. The advantage is that, in theory, you get all your pain at once and then can begin to recover from what would be a very bad and deep recession. The bad news is that you risk getting 30% unemployment and another depression that could take a very long time to climb out of.

Now, let me say that I have GREATLY simplified their argument. If you want to learn more you can go to www.mises.org. It is an excellent web site for all things Austrian. While I am not Austrian, I have spent a lot of time reading the literature and have certain sympathies for this view.

That being said, this also has almost no chance of being implemented. In Congress, only my friend Ron Paul is its advocate. Most Austrian followers are Libertarian by nature, and that is just not a political reality for the coming decade.

The Eastern European Solution

As it turned out, Niall Ferguson (last week I wrote about his brilliant book, The Ascent of Money) was in Dallas last night, and I was graciously invited to hear him. He gave a great speech and signed books, and then we went to a local bar and proceeded to solve the world's problems over Scotch (Niall) and tequila (me), and went farther into the night than we originally intended. He's a very fun and knowledgeable guy.

As we were talking about possible paths, he brought one to mind that I hadn't thought of. He reminded me of the period after the fall of the Berlin Wall, as the nations of Eastern Europe broke from the former Soviet Union. They started with very weak economies and simply overhauled their entire governments and economies in a rather short period of time, though not in lockstep with one another. Privatization, lowered taxes, etc. were the order of the day.

We here in the US are always talking about the need for reform. We need to reform health care or education or energy. In Eastern Europe they did not reform in the sense that we use the word. In many cases they simply started from scratch and built new systems. They had the advantage that there was general agreement that things did not work the way they had been, so there was more room for change.

Today in the US there are large constituencies that resist change. We only get to tinker around the edges, when real structural change is needed. Sadly, we agreed that here there is not much chance of major change. We can't even get the obvious changes needed in the financial regulatory world.

Sidebar: I am outraged at the paltry proposed financial "reforms." Rahm Emanuel said that no crisis should be allowed to go to waste. The Obama administration is wasting this one. How can we allow banks to be too big to fail? Where is the reinstatement of Glass-Steagall? If we are going to allow large banks to exist, then their leverage must be reduced to the point where their failure would not risk the system and require taxpayer dollars. I don't care if that makes them less profitable. They are making those large profits because they have taxpayers implicitly behind them, and I get no dividend payments from them, the last time I checked. Where is Fannie and Freddie reform (and their breakup)? No mention of an exchange for credit default swaps? (And yes, I know that such an exchange would reduce the number of swaps and the profitability of them. That is the point. They are dangerous if allowed to become too big a market.) This bill reads as if bank lobbyists wrote it. Where is the populist outrage? We have let the fox set up the rules for running the hen house. Shame on us all if we allow this to happen.

Japanese Disease

I have written a lot over the past year about the problems facing Japan. Their population is shrinking, as is their work force. They are running massive fiscal deficits and have done so for almost 20 years. Government debt-to-GDP is now up to 178% and projected to rise to over 200% within a few years. They started their "lost decades" with a savings rate of almost 16%, and are now down to 2% as their aging population spends its savings in retirement. They have had no new job creation for 20 years, and nominal GDP is where it was 17 years ago.

As bad as our problems are here in the US, their bubble was far more massive. Values of commercial property fell 87%! Their stock market is still down 70%. They had twice as much bank leverage to GDP as the US. (Think about how bad off we would be if bank lending was twice as large and had even worse defaults and capital shortfalls!)

And yet, they Muddle Through. Productivity has kept their standard of living reasonable. Up until recently their exports were strong. The trading floors of the world are littered with the bodies of traders who have shorted Japanese government debt in the belief that it simply must implode. While I believe that it eventually will, if they stay on the path they are on, Japan is a very clear demonstration that things that don't make sense can go on longer than we think.

Richard Koo (chief economist of Nomura Securities, in Tokyo) argues passionately that Japan had a balance-sheet recession, and that the only way for Japan to fight it was to run massive deficits. Banks were not lending and businesses were not borrowing, as both groups were trying to repair their balance sheets, which were savaged by the bursting of the bubble. It is said that at one time the value of the land on which the Emperor's Palace sits in Tokyo was worth more than all of California. Clearly this was a bubble that puts our housing bubble to shame.

So, I understand the point that there are differences between Japan and the US . But there are also similarities. We too have had a balance sheet recession, although here it was mostly individuals and financial institutions that have had to retrench and repair their balance sheets.

Japan elected to run large deficits and raise taxes. As I wrote in the October 16^th letter (http://www.investorsinsight.com/blogs/thoughts_from_the_frontline/archive/2009/10/17/muddle-through-r-i-p.aspx), "Savings equal Investments:

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

I don't want to go on at length again, but basically, the literature I quoted suggests that government stimulus and deficits have no long-run positive effect on GDP. In fact, the work done by Christina Romer, Obama's chairman of the Council of Economic Advisors, shows that tax cuts have a three-times-greater positive effect on GDP, and tax increases have the same level of negative effect.

In the equation above, if you increase government spending it will have a positive effect in the short run on GDP, but not in the long run. In essence, the increase in "G" must be made up by savings from consumers and businesses and foreigners.

But "G" does not enhance overall productivity. Government spending may be necessary but it is not especially productive. You increase productivity when private businesses invest and create jobs and products. But if government soaks up the investment capital, there is less for private business.

And that is Japanese disease. You run large deficits, sucking the air out of the room, and you raise taxes, taking the money from productive businesses and reducing the ability of consumers to save. Then you go for 20 years with little or no economic or job growth.

This is the path we currently seem to be on. The Japanese experience says that it could last a lot longer than people think before we hit the wall; because if savings rise in the US, and if banks, instead of lending, put that money on deposit with the Fed, as they are now doing (in order to repair their balance sheets), the US could run large deficits for longer than most observers currently believe.

We will need 15-18 million new jobs in the next five years, just to get back to where we were only a few years ago. Without the creation of whole new industries, that is not going to happen. Nearly 20% of Americans are not paying anywhere close to the amount of taxes they paid a few years ago, and at least ten million are now collecting some kind of unemployment benefits or welfare.

Choosing large deficits does not reduce the amount of pain we will experience, it just seemingly reduces it in the short term and creates the potential for a serious economic upheaval when the bond market finally decides to opt for higher rates. This path is a bad choice, but sadly, in reality it is one we could take.

The Glide Path Option

A glide path is the final path followed by an aircraft as it is landing. We need to establish a glide path to sustainable deficits (could we dream of surpluses?). That is because at some point there will be recognition, either proactively or forced upon us by the bond market, that large deficits are unsustainable in the long term.

If Congress and the president decided to lay out a real (and credible) plan to reduce the deficit over time, say 5-6 years, to where it was less than nominal GDP, the bond market would (I think) behave. Reducing deficits by $150 billion a year through a combination of cuts in growth and spending would get us there in five years.

The problem is that there is real pain associated with this option. Remember that equation above. Absent a growing private sector, if you reduce "G" (government spending) you also reduce GDP in the short run. You have to take some pain today in order to do that. But you avoid worse pain down the road: a bubble of massive federal debt that has to be serviced will be very painful when it blows up, as all bubbles do.

The Glide Path Option means that structural unemployment is going to be higher than we like (which is actually the case with all the options). And the large tax increases that come with this option will by their very nature be a drag on growth (and cause a double-dip recession in 2011). We can debate tax increases all we want, but I sadly think we will soon have a VAT tax. There are no good options. I just hope that we cut corporate taxes enough when we do create a VAT, that it will make our corporations more competitive, which will be a boost for jobs.

That's pretty much it. This is not a problem we can grow ourselves out of in the next few years. We have simply dug ourselves into a huge hole. This is not a normal recession. There is not a "V" ending to this recession. We are going to have deal with the pain. It will be the pain of reduced returns on traditional stock market investments, a lower dollar, low returns on bonds, European-like unemployment, lower corporate profits over the long term, and a very slow-growth environment. But if we choose this path, we will get through it in the fullness of time.

And of course, then we will eventually have to deal with the $70 trillion in our off-balance-sheet liabilities in Medicare and Social Security and pensions. Sigh. But that's for another time.

Philadelphia, Orlando, and Phoenix

I really am more optimistic than this letter makes me seem. But if you ignore reality, then you have no chance to figure out how to make the best of your situation. It is the efforts of hundreds of millions of individuals trying to make their own lot a little better than will get us back to a robust economy.

Monday I fly to Philadelphia and then the next day to Orlando for two speeches, and then the following week a quick trip to Phoenix, then home to start to plan for Thanksgiving. I will be in New York the first weekend of December (the 4^th) for Festivus, a great fundraiser for kids sponsored by Todd Harrison and the team at Minyanville (http://www.rpfoundation.org/), Interestingly, they hold it every year at a "Texas" barbecue joint. Look me up if you are there.

Tiffani has been out the last two days of this week. She is due in seven weeks or less, and her hips are expanding. The pain is too much right now for her to walk up the stairs to the office, so she is working from home. The doctor says this is the one time that her pain is not a sign of something bad. She is being a trooper and not taking any pain meds.

It has been 30 years since I was around a pregnant lady for more than a few hours, and it does bring back some memories. Watching her grow and change has brought back the sense of awe over how our bodies are designed.

Ryan and Tiffani have decided on the name Lively for my first granddaughter, to add to the two new grandsons this year. From zero to three grandkids in just six months! Kind of makes me dizzy.

I really enjoyed my time in South America. Rio is quite beautiful and I want to go back and spend some time.

Have a great week. There will be enough good friends and family that I know I will. And tomorrow night I finally get to go to a Dallas Mavericks game. We may have a real team this year.

Your always optimistic at the beginning of the season analyst,

John Mauldin

Catching Argentinian Disease

John Mauldin — Sat, 31 Oct 2009 02:47:00 GMT

Catching Argentinian Disease?
The Ascent of Money
The Independence of the Fed Threatened
A Few Quick Thoughts on the Dollar, GDP, and the Recession
Uruguay, Philadelphia, Orlando, and then...

I have been in South America this week, speaking nine times in five days, interspersed with lots of meetings. The conversation kept coming back to the prospects for the dollar, but I was just as interested in talking with money managers and business people who had experienced the hyperinflation of Argentina and Brazil. How could such a thing happen? As it turned out, I was reading a rather remarkable book that addressed that question. There are those who believe that the United States is headed for hyperinflation because of our large and growing government fiscal deficit and massive future liabilities (as much as $56 trillion) for Medicare and Social Security.

This week, we will look at the Argentinian experience and ask ourselves whether "it" - hyperinflation - can happen here.

The Ascent of Money

I will be quoting from Niall Ferguson's recent book, The Ascent of Money. I cannot recommend this book too highly. In fact, I rank it up with my all-time favorite book on economic history, Against the Gods, by the late (and sorely missed) Peter Bernstein. There are very few books I read twice. There are too many books and not enough time. This book I will have to read at least three times, and soon, and I have a lot of underlines and mark-ups in it already.

If there were one book I could require every member of the Congress to read, it would be this one. As I read it, I am struck again and again by how fragile and yet resilient our economic systems are. Fragile in the sense that governmental policy mistakes, no matter how well-intentioned, can destroy the wealth of a nation, and resilient in that it doesn't happen more often.

In his introduction Ferguson writes, "The first step towards understanding the complexities of the financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present day roles much easier to grasp."

As is often said, those who do not understand history are doomed to repeat it. If you want to understand what is happening in the economy, what the consequences of our choices could be, then I strongly suggest you get The Ascent of Money. It is easy to read, engaging, full of moments where you are led to pull together different ideas into an "Aha!" Ferguson is a brilliant writer and historian, and we are lucky to have this book at a time when it is sorely needed. (order it at Amazon.com)

As I have been writing, the United States in particular, and the developed world in general, are faced with a series of very unpleasant, if not downright bad choices. The time for good choices was ten years ago. Now we face the prospect of painful decisions, no matter what we do. It is not a matter of pain or no pain, of somehow avoiding the consequences of our bad decisions, it is simply deciding how much pain we will take and when, or allowing the pain to build up to a climactic event. Today we look at what I think would be the worst choice of all.

Catching Argentinian Disease

At the beginning of the 20^th century, Argentina was the seventh richest nation on earth. It's very name means "silver." "As rich as an Argentine" was a byword. Even after falling from the heights through a series of bad decisions, the country was still so wealthy that, in 1946 when new president Juan Peron first visited the central bank, he could remark that "There was so much gold you could barely walk through the corridors."

Argentina had actually defaulted on its debt in the late 19^th century, not once but twice! But still they managed to avoid destroying the currency and devastating the country. But in 1989, after years of massive budget deficits that were financed with borrowing from abroad and Argentinian citizens, the country was left with so much debt and no one was willing to lend it any more money, that the leaders felt compelled to resort to the printing press.

My Uruguayan friend and Latin American partner, Enrique Fynn, tells me of his experience of going to Buenos Aires and buying a pack of cigarettes one evening. He went into the store the next morning for another pack, and the price had doubled. He came back that evening and the price had doubled again (thankfully for his health, he has quit!). There were no prices on any items in the grocery stores. There was a man with a microphone who would announce the prices of various items, often increasing the price every few hours by 30% or more.

Workers would get their pay in cash and rush to the store to buy anything, as by the end of the week their pay would be worthless. Of course, shelves were empty. The US dollar was king, and could purchase things at amazing prices. I heard stories that were truly compelling. (It made me wish I had gone shopping in Buenos Aires at the time!)

Interestingly, the dollar is still the real medium of exchange. I was told by several people that if you want to buy a house for half a million dollars, you bring the physical cash to the closing. One person counts the money and the other checks the paperwork and title. Argentina has the second largest hoard of physical dollars in the world, only exceeded by Russia. Is it any wonder they are concerned with the value of the dollar?

Let's look at some quotes from Ferguson (emphasis mine):

"The economic history of Argentina in the twentieth century is an object lesson that all the resources in the world can be set at nought by financial mismanagement... To understand Argentina's economic decline, it is once again necessary to see that inflation was a political as much as a monetary phenomenon...

"To put it simply, there was no significant group with an interest in price stability...

"Inflation is a monetary phenomenon, as Milton Friedman said. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country's political economy."

Look at the chart below. Using realistic assumptions, It suggests that the annual US government fiscal deficit will approach $2 trillion in 2019. How can we come up with what looks to be about $15 trillion over the next ten years? The Argentinian answer was to print the money.

In the US, the short answer is that unless the US consumers become a massive saving machine, to the tune of 8% or more of GDP and rising each year, and willingly put their savings into US government debt, it's not going to happen. So sometime in the coming years, interest rates are likely to start to rise in order to compensate bond investors for what they perceive as risk. That will bring us to some very difficult and painful choices.

As I wrote a few weeks ago, this scenario could be averted IF the Obama administration produced a credible plan to lower the deficit over time and stuck to it. But today's thought process is about what happens if they don't.

Ferguson pointed out in the quotes above that hyperinflation is always and everywhere a political decision. Governments have to choose to print money. In theory and in practice, what would happen if the Fed decided to accommodate a politicized US government that wanted to spend money on favorite projects and support groups, maybe even deserving programs like health care or defense or pensions or Social Security? Money they could not borrow?

Then Peter Schiff and like-minded thinkers would be right. Once you start down that path, it is hard to stop short of the brink. Brazil got to 100% inflation per month and has really lowered that level over time, but it is not easy.

In such a scenario, you want to own hard assets. Gold. Foreign currencies. Stocks. Almost anything other than the currency that is being printed.

I was asked at almost every speech about that scenario. In Latin America, hyperinflation is not a theoretical issue; it has been reality. More than one person commented on that no one in US economics schools studies hyperinflation. It is required material in Latin America. For many Latin Americans, the dollar has been their safe haven. And now they are worried, with good reason.

For the record, I do not think the US will experience hyperinflation as long as the Fed maintains its independence. Read the speeches from various Fed governors and regional presidents. These are strong personalities, and they understand that going down that path ends in massive tears. Bernanke warned just a few weeks ago that the government needs to get serious about the fiscal deficit. Watch the rhetoric from the Fed heat up after his reconfirmation and the confirmation of two new governors in the first quarter.

The Fed has committed to buy a fixed amount of government debt in its quantitative easing program. That commitment will be finished by the end of the first quarter (if I remember correctly). Then comes the tricky part.

I have been writing for a long time that the main force in the economy right now is deflation. The Fed will fight deflation tooth and nail. But they don't have to buy government debt to fight deflation. They can buy mortgage securities, credit card securities, commercial paper, etc. That will have the effect of easing without encouraging the government to run massive deficits. And such debts are naturally self-liquidating, while government debt is not, at least not in the same way.

I believe the Fed will maintain its independence. Not to do so is to court economic disaster of the first order. These are bright and serious men and women. They get it.

The Independence of the Fed Threatened

The risk is that something changes to compromise their independence. And sadly, there is some risk. Let me quote my fishing buddy friend David Kotok:

"It's now official. The proposed legislation to reform America's financial service supervision includes granting the Secretary of the Treasury a veto over Section 13(3) emergency action by the Federal Reserve Board of Governors. If this becomes law, it will be a sad day for the independence of America's central bank.

"The Secretary of the Treasury, a very senior cabinet position, is appointed by the President and meets with the President in the Oval Office weekly. The governors of the Federal Reserve Board are also appointed by the President. Both cabinet officers and Federal Reserve governors are confirmed by the US Senate. There are supposed to be seven governors; politics has purposefully limited this to five throughout the three-year financial crisis period.

"The Federal Reserve governors are supposed to serve staggered 14-year terms with all seven seats filled. Instead, we have been governed by the present five-member, politically configured board.

"The original seven-governor construction was designed to insulate them from political pressure, for very good reasons. Decades of monetary history throughout the world have disclosed what happens when political influence on a central bank intensifies. The Weimar Republic and Zimbabwe are evidence of the worst inflationary effects of politics. The Great Depression in the US and the nearly two-decade deflationary recession in Japan demonstrate that monetary policy is not only inflation-prone. When central banks are under political influence you can get fire or you can get ice.

"In Japan, the central bank contends with two members of the cabinet sitting in on its deliberations. There is no way to know how much of the last 15 years of deflation and recession is attributable to the inside political pressures placed on the governors of the Bank of Japan. But there is evidence to suggest political influence, especially when you observe how little the Bank of Japan has engaged in asset expansion during this crisis."

This is the nose of the camel under the tent. Starting down this road is very worrisome indeed. I find it appalling that Tim Geithner and Larry Summers went along with this. This is a very clear attempt by the political class to put political pressure on the Fed. I hope the Fed responds with vigor. I can tell you that the officials of whom I am aware will not take kindly to pressure. And that might be an understatement.

(Yes, I am aware of the problems of the Fed being able to decide whom to bail out and why. It is not a perfect world. But better the Fed than Congress.)

All that being said, if the Fed starts to increase its buying of government debt above its initial commitment, then my "optimistic" scenario of a very rough economic patch, which I have been outlining the past few months, is far too rose-colored. I do not think it will happen, but I can guarantee you, I and a lot of other people will be watching.

A Few Quick Thoughts on the Dollar, GDP, and the Recession

Just a few quick notes. When world trade collapsed, so did the need for US dollars, which is what the world uses to transact business. The data looks like world trade is finding a bottom and maybe even recovering somewhat. That means there will be the need for more dollars. And since everybody and their mother are short the dollar, there could be a vicious snap-back rally. I am still bearish the US dollar (and the yen and the euro and the pound) over the long term, but there is the potential for a real rally here.

And my friend Mish Shedlock commented on the US GDP report, which said the US GDP rose 3.5%:

"Today the market is cheering over what is actually an ugly report. A misguided Cash-for-Clunkers added a one-time contribution of 1.66 percentage points to GDP. Auto sales have since collapsed so all the program did is move some demand forward. Government spending increased at 7.9 percent in the third quarter which is certainly nothing to cheer about. Personal income decreased $15.5 billion (0.5 percent), while real disposable personal income decreased 3.4 percent, in contrast to an increase of 3.8 percent last quarter. Those are horrible numbers. The savings rate is down, which no doubt has misguided economists cheering, but people spending more than they make is one of the things that got us into trouble. The only bright spot I can find is exports. However, even there we must not get too excited as imports rose much more."

John Williams notes that one-time stimulus or inventory items represented 92% of the reported quarterly growth. The nature of the stimulus-related gains was that they tended to steal business activity from the future. The months ahead are the future. Accordingly, fourth-quarter quarterly GDP change will likely turn negative, again. (The King Report)

And David Rosenberg writes: "Only economists see the recession as being over; the man on the street sees it a little differently, perhaps less enthused by the fact that a lower rate of inventory destocking is arithmetically underpinning GDP growth at this time. Put simply, a Wall Street Journal/NBC News poll just found that 58% of the public believe the economic recession still has a ways to go -- and that is up from 52% in September and means that the private investor, unlike the hedge fund manager, is not interested in adding risk to the portfolio even after a 60% surge in the equity market.

"Only 29% of those polled believe the economy has hit bottom -- imagine having that psychology with nearly zero interest rates, a bloated Fed balance sheet and unprecedented fiscal deficits (poll was taken from October 23-25). Nearly two in three (64%) said the rally in the stock market (still a bear market rally -- not the onset of a new bull market) has not swayed their view (or ours for that matter)."

Uruguay, Philadelphia, Orlando, and then...

I am finishing this letter in Montevideo, Uruguay. I have been in Buenos Aires, Sao Paulo, and Rio de Janeiro this week. I must say that Rio is beautiful, very green and lush with marvelous beaches, which I sadly only got to drive past. I will come again. I fly back Sunday and am home for a week, then speaking trips to Philadelphia and Orlando. Then my schedule only shows a few days in New York in early December for Festivus with the gang from Minyanville, and Europe in January. I am sure other things will come up, but I am looking forward to being home for awhile.

My friends at International Living have been writing about Uruguay, and I was really looking forward to visiting the country. I have spent a few days with partner Enrique Fynn in this delightful place. Turns out it is the Switzerland of South America. Reasonable bank secrecy laws, and trades zones where you are not taxed on any business you do outside of Uruguay. Many international companies set up their headquarters here. Beautiful beaches, friendly people, and the charm of a small country, plus what will be a brand new airport in a few weeks, which can get you several times a day to any part of the region, directly to Europe, and one hop away from any major city in the world. You can learn more about the country, and other countries you may want to live in or have a second home in, by subscribing to International Living.

One of the laugh lines I use in my speeches down here is that if the Fed actually does start to monetize the debt, I will have to move to Uruguay. I could make worse choices.

Have a great week. I think this weekend I will switch it up from the heavy reading I have been doing and find some science fiction. Reality is way too scary.

Your ready to be in his own bed analyst,

John Mauldin

Muddle Through, R.I.P?

John Mauldin — Sat, 17 Oct 2009 19:50:00 GMT

Muddle Through, R.I.P?
Savings Equal Investments
Japanese Disease
Who Will Buy the Debt?
The New Muddle Through Economy
On the Road Again

I first wrote about the Muddle Through Economy in 2002, and the term has more or less become a theme we have returned to from time to time. In 2007 I wrote that we would indeed get back to a Muddle Through Economy after the end of the coming recession. If you Google the term, at least for the first four pages more than half the references are to this e-letter. I get a lot of flak from both bulls and bears about being either too optimistic or too pessimistic. Being in the muddle through middle is comfortable to me.

Last week I expressed my concern that we as a country are taking actions that could indeed "Kill the Goose" of our free-market economy. I rightly got letters asking me how I could maintain Muddle Through in the face of that letter. I have given it a lot of thought and research. How likely are we to muddle through in the face of $1.5 trillion and larger deficits? Today we take another look at Muddle Through. It should be interesting.

But first, two housekeeping items. I want to welcome the 150,000 members of the National Association of the Self-Employed to this letter. They have asked me to be a special consulting economist to their group, and they will send this letter each week to their members. Since its beginning in 1981, the National Association for the Self-Employed has pioneered support for micro-businesses and the self-employed, and been a forceful advocate for small business in this country. (www.nase.org) I am honored. I am pleased to add you to my 1 million closest friends. I hope you find it useful.

Second, I will be going to South America at the end of next week, to Buenos Aires, Montevideo, Sao Paulo and Rio. I will be speaking in those cities and traveling with my new Latin American partner, Enrique Fynn of Fynn Capital (based in Uruguay). If you would like to find out about this tour or what services he can help you with, you can go to www.accreditedinvestor.ws and sign up and Enrique will get in touch with you. And as always, if you are an accredited investor, you can go to that website and one of my partners in the world will get back to you. (In this regard, I am president of and a registered representative of Millennium Wave Securities, LLC, member FINRA.) And now to the letter.

Muddle Through, R.I.P.?

I defined a Muddle Through Economy in the past as one of slow growth (in the area of 1-2%) and a slack employment environment, such as we had in 2002 and the early part of 2003. In early 2007, I suggested we would return at some point to such an environment at the end of the recession I was predicting.

I am not surprised about the response of the Fed to the current recession and credit crisis, whether it's the large monetization of debt or the low interest rates. Assuming they more or less remove the monetary easing in a reasonable manner, there is nothing that would make me think we do not eventually recover, albeit at a very slow Muddle Through pace, with a jobless recovery that lasts for several years. It will not be pleasant, but we'll survive.

However, gentle reader, never in my wildest dreams did I think we could be looking at government deficits of $1.5 trillion dollars and actually budgeting future deficits of over $1 trillion as far as the eye can see. And there is real reason to think that under current plans, $1 trillion deficits are optimistic. Look at the graph above from the Heritage Foundation. They suggest that current policy would bring us closer to a $2 trillion deficit by 2019.

And that assumes nominal growth that is north of 3% and unemployment dropping back below 5% in reasonably short order. If you make less optimistic assumptions, the number can become much larger rather quickly. Where do we find that much money to finance that large a deficit? We will look at what might be the answer, but first we need to look at a basic concept in economics.

Savings Equal Investments

GDP (Gross Domestic Product) is defined as Consumption (C) plus Investment (I) plus Government Spending (G) plus [Exports (E) minus Imports (I)] or:

GDP = C + I + G + (E-I)

(For the wonks out there, GDP is usually termed "Y".)

You can calculate national savings as GDP minus consumption and government spending. That means that investment equals savings plus net exports. If there are no net exports, then money must come back into the US from outside the country to finance investments, along with savings.

This equation is known as an identity. An identity is an equality that remains true regardless of the values of any variables that appear within it. That means it is not a guess or an approximation. It is simple reality.

Thus, if there is a government deficit, there must be savings by both consumers and businesses, plus capital flows from outside the country, to offset that deficit in order for there to be any money left over for investments.

In the short run, an increase in government spending can offset a decline in consumption (a recession), but absent savings a government deficit crowds out investment in the long run. There must be savings in order for there to be investment. And without investment, you do not get job growth or economic growth.

Japanese Disease

Some readers wrote this week telling me I am far too worried about a rising government deficit. Right now we are at roughly 42% of debt to GDP. In 1989, at the start of the lost decades, Japan had a debt-to-GDP ratio of 51%. Now it is at 178%, and the world has not come to an end for them. In fact, they are running massive government deficits today and plan to do so for a long time. Why, I am asked, can't we be like Japan? And my answer is that it is possible, but the cost that Japan has paid has been high.

In 1989, private Japanese debt (businesses and consumers) was at a debt-to-GDP ratio of 212%. Now it is at 110%. And the total of both government and private debt is roughly the same (within 5%) of where it was 20 years ago. Along with running large trade surpluses, private debt has been exchanged for government debt. Savings have fallen from the mid-teens to about 2% today, as the country is rapidly aging and now using its savings to live on. And how much has all that government spending helped the country? Before I answer that, read these paragraphs from Hoisington Asset Management's latest letter (last week's Outside the Box):

"The federal government's promise to extricate the U.S. economy from this recession involves more spending (increasing public debt) and more subsidies for consumers, such as car rebates and home buying incentives (more private debt). In other words, more debt is supposed to solve the problem of over-indebtedness. The truth is that this policy merely indentures its citizens further without providing any income for repayment of debt. In previous letters we have discussed the fact that the government spending multiplier is zero (read Professor Robert Barro's book, Macroeconomics - a Modern Approach, p. 370).

"This means there is no long term income benefit from stimulus programs. According to the latest academic research, the most recent $800 billion stimulus plan will boost economic activity in the short run, but will surely depress economic activity over time. The government problem is complicated by the fact that the tax multiplier is 3, meaning that a 1% change in taxes will change GDP by about 3% over time. More recent research (Barro & Redlick, September 2009, "NBER Working Paper 15369") suggests that a 1% cut in the marginal tax rate would raise GDP in the ensuing year by 0.6%. With the deficit rising due to a zero spending multiplier, the tendency will be to try to raise taxes to pay for this higher level of expenditures, which will further depress aggregate spending and output."

For all intents and purposes, Japan has had no growth for almost two decades. Their nominal GDP is where it was 17 years ago, and the number of employed people is at 20-years-ago levels. An aging population has masked their unemployment problems, as older citizens retire. Their savings went to government debt. Taxes were raised numerous times. Since government deficit spending has no long-term multiplier effect, growth has been nonexistent. (By the way, that research about multiplier effects has also been done by Christina Romer, the chairman of the current President's Council of Economic Advisors, and further explored by European economists. There is general agreement on these facts.)

In 1998, the US had a total debt- (government plus private) to-GDP ratio of 260%. Today it is 373%. We have added over $15 trillion in debt, yet total employment today is roughly where it was 9 years ago. But the current economic leadership wants to solve the problem of too much debt with even more debt. I am sympathetic with the idea that in the short run the government should step in and the Fed should print (within limits) money to keep us from deflation. But the equation we spent time on earlier suggests that if we continue to run massive deficits, we run the risk of catching Japanese disease - a decade-long (or longer) period of slow growth and high unemployment, especially since our population is growing and our Boomers are going back to work (and surveys suggest they intend to work longer).

Large government deficits choke off the very investment that we need to create jobs. In the name of doing good, the unintended consequence is to make it more difficult for small businesses to start up and create jobs. And we all know that small business is the engine for job creation.

The way out of the current morass is to create jobs and increase productivity. But if the government runs deficits of $1.5 trillion, that means whatever savings (corporate and consumer) we have will not go into the investments we need, but into government debt.

Who Will Buy the Debt?

Now, let's go back to the problem of who will buy the debt. How can we find $1.5 trillion each and every year? Some of it will come from foreign central banks, as we continue to run a trade deficit. Once those dollars leave our shores, they do not disappear. They can only go back into a dollar-denominated investment. Up to now, that has typically been US government debt. If China decides to use its dollars to buy commodities or other assets, whoever sells them the assets now has the dollars and must decide what to do with them. So give or take a few billion, about $400 billion will come back to the US from our trade deficit next year. That still leaves $1.1 trillion.

Upon reflection, and cutting to the chase, I think that the buyers of the debt could be US banks for quite some time. The next graph shows commercial and industrial loans at US banks falling precipitously. Banks have (correctly) tightened lending standards, but that means that small and medium-sized businesses, which account for over 85% of all jobs, have been cut off from the life blood of growth. Is it any wonder they are cutting jobs at a prodigious rate?

The next graph shows bank credit (of all types), going back to 1974. Notice that even during recessions (gray shaded areas) bank lending either grows or at the most goes flat. But now we are experiencing something new: bank lending is falling. Notice the sharp increase in lending in 2008 as corporations decided to draw down their banks' lines of credit, afraid that the banks might cut back. And with good reason, as banks did exactly that.

So where do banks put their cash and reserves they are not lending? At the Fed and in Treasury debt. If you can leverage capital at ten to one (as banks can) and if you get 2% (for longer-term debt) and if you only have costs of, say, 50 basis points (or 0.5%), you can make a return on equity of 15% with no risk.

And that is what we are seeing. Banks are taking the money the Fed is printing and the government is giving them and putting it back at the Fed. Bank reserves at the Fed are exploding. And they are likely to continue to do so, since bank balance sheets are still deteriorating, especially at smaller and regional banks exposed to commercial real estate loans. Banks own 45% of commercial real estate loans, compared to only 21% of single-family loans. Banks (in general) are going to have to raise capital and reduce their loan portfolios in order to keep within the guidelines for adequate reserve capital. Small wonder that my friend Chris Whalen (one of the real experts on banks) thinks we will see over 400 banks fail in this cycle.

One quick chart to further highlight the problem that banks are facing. I have been writing for several years that commercial real estate loans will be the next shoe to drop. Moody's calculates that commercial real estate prices have dropped 30%. Over a trillion dollars in commercial real estate loans are coming due in the next few years. Banks are going to continue to reduce their loan portfolios in order to deal with the massive write-offs they are going to have to make. And my bet is they put those reserves they are not lending into government debt.

Given that the current Congress is hell bent on massively raising taxes in 2011, we are likely to dip back into recession by then, if not before. Remember, taxes have a multiplier effect of three. That means tax cuts increase GDP (over time) by three times their amount. But tax increases reduce GDP by three times the increase. That will make deficits worse, and unemployment will again start to rise from already high levels. Twenty states have already raised sales taxes, and more are raising other taxes. It is a vicious spiral.

The New Muddle Through Economy

This is not a prescription for a return to normal growth. We are headed for a New Normal that is less than what the market currently believes. Unless the deficit comes under control at some point, we face the real prospect of catching Japanese Disease and suffering yet another lost decade. Can we Muddle Through? We have no choice but to do so. But it will not be fun. It will not be long-term 2% growth and employment going back to 6% any time soon. Can we reverse the course? With a different attitude and leadership in Congress, maybe we can. But it won't happen next year, and it's unlikely in 2011.

I am afraid we will have to put my old friend Muddle Through, as I previously defined him, back in his box for a while. But wait, if my friend at PIMCO, Mohammed El-Erian, can tell us we are going to a "New Normal," then I can decide that we are going to a "New Muddle Through Economy." Just not one as benign as I used to think.

In the end, that is what we will do. We will figure out how to deal with the environment in which we find ourselves. That is what free markets and entrepreneurs do. Things will sort out, but not before we have what could be an even more difficult crisis, which will force us to make hard choices.

As an aside, I am not expecting that we will see the crisis I am thinking of any time soon. We can move along with positive GDP for some time. I am thinking of the longer term, 1-3 years out. We will become complacent. I will get letters telling me I am too pessimistic. Just as I did in late 2006 when I said we would be in a recession by late 2007. But I firmly believe we will see a double-dip recession within another 18 months (at the most). Stock markets drop on average about 40% in a recession. Adjust your portfolios accordingly.

On the Road Again

I am writing tonight from Detroit. Tomorrow I will be in New York watching the Yankees/LA game. I will be the guy in the second row behind home plate in the Dallas Cowboys jacket. I will be on Yahoo Tech Ticker on Monday morning, so you should be able to go to Yahoo and see me later that afternoon. Then Philadelphia on Tuesday, speaking at my partner Steve Blumenthal's CMG conference for investment advisors. They have a very interesting platform of trading advisors. You can see them at http://cmgfunds.net/public/mauldin_questionnaire.asp

I had a great deal of fun at the New Orleans conference, being with old friends and meeting new ones. David Tice (of the Prudent Bear Fund) was an exceptional host for dinner at Emeril's. I was surprised that Karl Rove actually remembered me after nine years. I thoroughly enjoyed spending some quality time with my friend Ron Paul. We share a lot of concerns about the future of the Republic. I was pleasantly surprised by how thoughtful Howard Dean was. And very personable.

I go to Houston on Wednesday, Orlando on Thursday, and then South America on Saturday. I will be doing a lot of writing from hotel rooms, but all in all it will be fun. You have a great week, and remember that in 10 years none of us will look back and want to return to 2009. 2019 will be better than we can possibly imagine. We just have to make sure we all get there!

Time to hit the send button and find an adult beverage. All the best,

Your going to miss the Old Muddle Through analyst,

John Mauldin

Killing the Goose

John Mauldin — Sat, 10 Oct 2009 03:07:00 GMT

Killing the Goose
What Were We Thinking?
Let's Play Turn It Around
Detroit, the Red Sox and the Yankees, and Traveling Too Much

Peggy Noonan, maybe the most gifted essayist of our time, wrote a few weeks ago about the vague concern that many of us have that the monster looming up ahead of us has the potential (my interpretation) for not just plucking a few feathers from the goose that lays the golden egg (the US free-market economy), or stealing a few more of the valuable eggs, but of actually killing the goose. Today we look at the possibility that the fiscal path of the enormous US government deficits we are on could indeed kill the goose, or harm it so badly it will make the lost decades that Japan has suffered seem like a stroll in the park.

And while I do not think we will get to that point (though I can't deny the possibility), for reasons I will go into, there is the very real prospect that the upheavals created by not dealing proactively with the problems (or denying they exist) will be as bad as or worse than the credit crisis we have gone through. This is not going to be something that happens overnight, and the seeming return to normalcy that so many predict has the rather alarming aspect of creating a sense of complacency that will only serve to "kick the can" down the road.

This week we look at the problem, and then muse upon what the more likely scenarios are that may play out. This is a longer version of a speech I gave this morning to the New Orleans Conference, where I also offered a path out of the problems. This letter will be a little more controversial than normal, but I hope it makes us all think about the very serious plight we have put ourselves in.

Let's review a few paragraphs I wrote last month: "I have seven kids. As our family grew, we limited the choices our kids could make; but as they grew into teenagers, they were given more leeway. Not all of their choices were good. How many times did Dad say, ‘What were you thinking?' and get a mute reply or a mumbled ‘I don't know.'

"Yet how else do you teach them that bad choices have bad consequences? You can lecture, you can be a role model; but in the end you have to let them make their own choices. And a lot of them make a lot of bad choices. After having raised six, with one more teenage son at home, I have come to the conclusion that you just breathe a sigh of relief if they grow up and have avoided fatal, life-altering choices. I am lucky. So far. Knock on a lot of wood.

"I have watched good kids from good families make bad choices, and kids with no seeming chance make good choices. But one thing I have observed. Very few teenagers make the hard choice without some outside encouragement or help in understanding the known consequences, from some source. They nearly always opt for the choice that involves the most fun and/or the least immediate pain, and then learn later that they now have to make yet another choice as a consequence of the original one. And thus they grow up. So quickly."

What Were We Thinking?

As a culture, the current mix of generations, especially in the US, has made some choices. Choices which, in hindsight, leave the adult in us asking, "What were we thinking?"

We made a series of bad choices and suffered the credit crisis because of it. Now, as a nation, we are in the middle of making an even worse choice, one that will leave us with no good choices - only choices of pretty bad to awful. Let's begin with a quote from a recent client letter by my friends at Hayman Advisors (in Dallas).

"Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero).

"There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.

"According to the current Office of Management and Budget (OMB) projections, US federal expenditures are projected to be $3.653 trillion in FY 2009 and $3.766 trillion in FY 2010, with unified deficits of $1.580 trillion and $1.502 trillion, respectively. These projections imply that the US will run deficits equal to 43.3% and 39.9% of expenditures in 2009 and 2010, respectively. To put it simply, roughly 40% of what our government is spending has to be borrowed. [Emphasis mine]

"One has to ask whether the US reached the critical tipping point. Beyond the quantitative measurements associated with government deficits and money creation, there exists a qualitative aspect to such a scenario that may be far more important. The qualitative perceptions of fiscal and monetary policies are impossible to control once confidence is lost. In fact, recent price action in metals, the dollar and commodities suggests that the market is already anticipating the future."

Let me point out that the deficits for 2010 assume a rather robust recovery, and so they could turn out to be much worse, especially if unemployment continues to rise and Congress decides (rightly) to extend unemployment benefits.

The interest on the national debt in fiscal 2008 was $451 billion. Even though the debt has exploded, the interest for fiscal 2009 is down to "only" $383 billion. My back-of-the-napkin estimate says that is over 20% of total 2009 tax receipts. I guess when you take interest rates to zero and really load up on short-term debt, it helps lower interest costs. (More on that future problem later.) http://www.savingsbonds.gov/govt/reports/ir/ir_expense.htm

The fiscal deficits are projected to be about 11% of nominal GDP, which is now roughly $14.3 trillion. The Congressional Budget Office currently projects that deficits will still be $1 trillion in ten years.

Last spring I published as an Outside the Box a very important paper by Dr. Woody Brock on why you cannot grow government debt well above nominal GDP without causing severe disruptions to the overall economic system. If you have not read it, or would like to read it again, click here.

I am going to reproduce just one table from that piece. Note that this was Woody's worst-case assumption, adding 8% of GDP to the debt each year, and not the 11% we are experiencing today. The Congressional Budget Office projections are now even worse, and that assumes a very rosy 3% or more growth in the economy for the next five years. Under Woody's scenario, the national debt would rise to $18 trillion by 2015, or well over 100% of GDP, depending on your growth assumptions. Take some time to study the tables, but I am going to focus on 2015 and not the outlier years.

$1.5 trillion dollars means that someone has to invest that much in Treasury bonds. Let's look at where the $1.5 trillion might come from. Let's assume that all of our trade deficit comes back to the US and is invested in US government bonds. Today we found out that the latest monthly trade deficit was just over $30 billion, or $370 billion annualized (which is half what it was a few years ago). That still leaves $1.13 trillion that needs to be found to be invested in US government debt (forget about business and consumer loans and mortgages).

Killing the Goose

$1.13 trillion is roughly 8% of total US GDP. That is a staggering amount. And again, that assumes that foreigners continue to put 100% of their fresh reserves into dollar-denominated assets. That is not a safe assumption, given the recent news stories about how governments are thinking about whether to create an alternative to the dollar as a reserve currency. (And if I was watching the US run $1.5 trillion deficits with no realistic plans to cut back, I would be having private talks too. They would be idiots not to do so.)

There are only three sources for the needed funds: either an increase in taxes or people increasing savings and putting them into government bonds or the Fed monetizing the debt, or some combination of all three.

Now the Fed is in fact monetizing a portion of the debt as part of its quantitative easing program, and US consumers are saving more. Tax receipts are way down. I can tell you there is a great deal of angst in New Orleans tonight about the Fed monetization. This is traditionally a "gold bug" conference, and many of the participants and speakers see only inflation in our future.

Long-time readers know that I think the Fed has been able to get away with its rather large monetization program because of the massive deflationary forces let loose in the world by the credit crisis, which is forcing a monster deleveraging regime all over the world. Where has all the money gone that the Fed has printed? Right back onto the Fed's balance sheet as bank reserves. The banks are not lending, so this money does not get into the system in the usual manner associated with fractional reserve banking. Until that happens, and is accompanied by increasing wages and employment, inflation is not in our immediate future.

And this brings us to our conundrum. You cannot continue to run deficits significantly larger than nominal GDP for too long without risking the demise of the economic system. Ask Argentina or any of the other nations where hyperinflation occurred, as detailed in the study mentioned above. But we are in a deflationary environment, so the Fed can monetize the debt far more than any of us suppose without risking immediate and spiraling inflation.

But there is a limit to the Fed's ability to do so without causing real inflation. First, as long as the Fed is independent, at some point they will simply have to tell Congress we can no longer monetize the debt. While I am sure that some of you doubt they would do so, the Fed officials and economists I have been around are pretty adamant about that. There is a line they will not be pushed past. It may be further than I like, but it is there.

The Fed cannot simply buy up all the debt needed to fund the government. Again, no one on the FOMC would either advocate or allow that. That would in fact start us down a very dangerous path rather quickly. Therefore, they must have a large number of willing bond buyers outside the Fed. The good news, gentle reader, is that we will find someone to buy that debt. That is also the bad news. Let's go back 30 years.

Legend now has it that Paul Volker single-handedly took the inflation bull by the horns and ripped them off. Now, it took fortitude to do that in the face of certain recession and high unemployment. Those were not fun days. But his partner in the deed was the bond market. Bond investors simply demanded higher returns, because they were really worried about inflation.

At some point, if we do not get the government deficit under control, the bond market is once again going to react. Seemingly overnight, real (inflation-adjusted) rates are going to rise, and will do so rapidly. And I am not talking about 1 or 2%. You just cannot have 8% of a $14-trillion GDP go into US government debt every year, forever, at today's low real rates.

Let's play a thought game. If you take 8% of US consumer spending and save it, and it finds its way into government bonds, you have reduced consumer spending and therefore the actual GDP. But how about those who want to invest in stocks? Foreign bonds and currencies? New businesses? Loans of all types? How much are we going to have to save to get the necessary capital? How high will the saving rate have to be to finance all those other activities in a world where debt securitization is still anemic?

Some will point to Japan and their government debt-to-GDP ratio, which will soon be over 200%, a far cry from where we are today. Why can't we grow our debt to 200%? Because the Japanese have long had a culture of saving and investing in government bonds. It's what you do to support the country. But even they will run into a wall as their savings rate continues to drop, because so many of their citizens are retired and are now selling bonds to finance retirement. They too are running massive fiscal deficits, on the order of the size of the US deficits. And does anyone really want to have two lost decades, like Japan?

How long can we go before there is an upheaval? I don't know. The markets can remain irrational or complacent for a lot longer than most of us think. It could be years. Or not. Suddenly, it will be July 2008 and the bond vigilantes stampede.

But now, we seemingly can borrow with no consequences. The deflation that is in the air, plus the lack of bank lending holds, down the normal inflation impulses. We as a nation are leveraging ourselves up. We're partying like it's still 2005. The music is playing and we are dancing. Our Congress is trying to figure out how to run even higher deficits.

At some point, the consequences will be significant. There are two paths, and it is not clear which one we will take. First, we might see inflation kick in and actual rates rise. Since so much of our national debt is short-term debt, that means yet another rise in the deficit as rates rise. Mortgage rates rise, putting pressure on the housing market. There will be even more pressure on commercial mortgages. Consumer debt will be harder to get and cost more. It will mean funding costs for businesses will rise, and that hurts employment. It would be a return to the 1970s of high interest rates and stagnant growth in a very slow-growth environment.

Second, we could see deflation kick in and, even though rates stay more or less where they are, real (after-deflation) rates could rise as they did in the '30s and in Japan.

Some of my most knowledgeable friends argue for the inflation side, and others take the deflation side. I tend to think the Fed will fight deflation until we get inflation, but the consequences will not be pleasant. There is no benign path.

How can we avoid such an upheaval? The only way is to make some very difficult choices. There have to be some adults making the choices, as the teenagers now in control clearly cannot make them.

As I have written in the past, we can run deficits of 2% of GDP for a very long time, which in a few years would be about $300 billion. It is my belief that if the bond market and world investors saw a credible plan to put us on a path to a deficit no larger than 2% of GDP, the dire upheaval that is in our future could be avoided.

But that will mean some painful choices. It is not a matter of pain or no pain, it is just deciding when and how bad it will be. The longer we wait, the worse the consequences.

Let's Play Turn It Around

There are businessmen who are called turnaround specialists. They come into companies that are sick but have a basic competency, and that with the right management can be made into viable concerns. Generally, the choices the new management makes are painful to those involved, but they are necessary if the enterprise is to remain a going concern.

So, for the next few pages, I am going to suggest some things we can do to turn the US around. They are not easy fixes, and I know a lot of readers will not like what they read or will disagree on points. But something like this is going to have to be done, or we risk killing the goose.

First, we must acknowledge the deficit is out of control, and spending must be cut. If we raise taxes by as much as the Obama administration now wants to, we will most assuredly put the country back into a deep recession in 2011. Think what raising taxes in 1937 did to a nascent recovery. A $3-trillion-dollar budget is 20% of the US economy. That is just simply too much.

Quick fact. The most credible studies show that government expenditures exert no multiplier effect on the economy. Actually, they show them to be very slightly negative. This is not just in the US. However, the tax effect has a multiplier of 3! If we raise taxes by $300 billion in 2011, that will slam the economy in the face. Further, we will collect less taxes than projected, as economic activity will fall.

You cannot cure a too much debt problem with more debt. We cannot borrow our way into prosperity. Every crisis of the past decades has been a result of too much debt and leverage and we seem to want to repeat the past mistakes, hoping that this time it will be different. It won't.

Ok, now let's play the Turnaround Hammer Game.

+ We should start with a 5% acrossthe-board cut in spending in all programs. Federal employees, except for military personnel, should see a 5% cut in pay as part of that program. The average federal worker makes $75,419 a year, while the average in the private sector is $39,751. The rest of us are taking pay cuts in the form of higher taxes. No cost of living increases, etc. We are on an austerity program and need to do what it takes. If a program is deemed too important to be cut, then another program has to be cut more.

Then the next year another 2.5% cut across the board. And then an absolute freeze on the overall budget size until the deficit is 2% or less of GDP.

+ Social Security must be fixed now. We all know that it is going to have to be done, so why not just do it? Means testing should be a part of the mix. As an idea, for every $10,000 in income a retiree has, he gets $1,000 less in SS payments. And increase the retirement age down the road. When SS was launched, retirement age was 65. But the average life span was 65. There are other things we can do, but whatever our poison of choice is, we need to take it.

+ Medicare must be revised, with real health-care reform. The national debt is $56 trillion if we count unfunded liabilities, much of which is Medicare. It will become a nightmare around the middle of the next decade. Adding more expenses now without cutting elsewhere makes no sense. If we kill the goose, no one will get anything excect very empty promises.

Side note: there actually is a lot of waste in the system. Software should be written that analyzes every patient and procedure and produces an outcomes-based analysis of what is reasonable, rather than throwing every test at every patient. And the government should make sure, even if it has to spend the money, that the updated system is in place in every hospital and clinic in the country. And doctors should be given access to it so they can decide what type of care is appropriate to prescribe. And health-care reform means tort reform.

Today, I got a note from a friend of mine who just had yet another heart attack. It seems his stent is now blocked by 50%. He is a vet, and his primary care is the Veterans Administration. The Veterans Hospital system will not do a procedure to unblock the stent until it is 70% blocked. He does not have any money, so he is simply waiting to have another heart attack. I am really looking forward to government-run health care.

+ Each year we allow almost 1 million immigrants into the US, mostly family of people already here. I suggest that for the next two years we stop that. Instead, let anyone who can buy a home, passes basic screening, and can demonstrate the ability to pay for health insurance immigrate to the US and get a temporary green card. If they behave, then the card becomes permanent after four years.

We almost immediately put a floor on the housing market, absorb the excess homes, and within a year the housing-construction market, along with the jobs that are now gone, will be back. That is stimulus that costs the taxpayers nothing.

+ While I can't believe I am writing this, taxes are going to have to rise, if for no other reason than this Congress is hell bent on raising taxes. But rescinding the entire Bush tax cuts, plus adding a 10% surcharge as Congress wants to do in one fell swoop, is an absolute guarantee of a recession. So do it gradually over (say) 4 years, and then reinstitute the cuts when the deficit is under 2% of GDP. Remember the negative tax-multiplier effect of raising taxes. And the definitive work on that was done by Obama's chairman of the Council of Economic Advisors, Christina Romer.

We should consider a VAT tax and a major cut/reorganization of the corporate tax. We need to encourage corporations to hire more, and you do that by taxing less. Let's make our corporations more competitive, not less. Our taxes are much higher than those of any of our major competitors. And please forget that insane carbon tax. If you want to cut emissions, do it straightforwardly by raising taxes significantly on gasoline. Don't back-door it on consumers. (And I am NOT advocating such a policy.)

+ An aggressive tax benefit for new venture-capital money that is invested in new technologies will result in new industries. The only way we can grow our way out of this mess is to create whole new industries, like we did in the late '70s and '80s. (Think computers and the internet and telecom.)

+ Unemployment is likely to continue to rise and last longer than ever before. We have to take care of the basic needs of those who want work but can't find it. Unemployment insurance should be extended to those who are still looking for work past the time for benefits to expire, and some program of local volunteer service should be instituted as the price for getting continued benefits after the primary benefits time period runs out. Not only will this help the community, but it will get the person out into the world where he is more likely to meet someone who can give him a job. But the costs of this program should be revenue-neutral. Something else has to be cut.

+ We have to re-hink our military costs (I can't believe I am writing this!). We now spend almost 50% of the world's total military budget. Maybe we need to understand that we can't fight two wars and support hundreds of bases around the world. If we kill the goose, our ability to fight even one medium-sized war will be diminished. The harsh reality is that everything has to be re-evaluated. As an example, do we really need to be in Korea? If so, why can't Korea pay for much of the cost? They are now a rich nation. There are budgetary fiscal limits to being the policeman for the world.

+ Glass-Steagall, or some form of it, should be brought back. Banks, which are subject to taxpayer bailouts, should not be in the investment banking and derivatives-creating business. Derivatives, especially credit default swaps, should be on an exchange, and too big to fail must go. Banks have enough risk just making loans. Leverage should be dialed down, and hedge funds selling what amounts to naked call options in any form, derivative or otherwise, should be regulated.

Let me see, is there any group I have not offended yet? But something like I am suggesting is going to have to be done at some point. There is no way we can continue forever on the current path. At some point, we will hit the wall. The fight between the bug and the windshield always ends in favor of the windshield. The bond market is going to have to see a credible effort to get back to a reasonable deficit, or we risk a very difficult economic environment. The longer we wait, the worse it will be.

It is not going to be easy to persuade a majority of Americans that we need to do something now. More realistically, we are going to probably have to begin to experience a crisis of some type to get politicians motivated to do something.

This last Tuesday, I spoke to the Financial Leadership Association at the University of Texas at Dallas. It was mostly undergraduates, and my assigned topic was how financial research impacts our investment decisions. In touched on the topic above, in less detail, but pointing out that at some point we are going to have to bring the deficit under reasonable control. I got some push-back, as some could not understand why we just couldn't keep running deficits, as we simply owe it to ourselves. I tried to explain, but for a few of them I was not getting through (though I think most got it). And these were the finance students! I shudder to think what the sociology department would be like.

We are not going back to normal, although it is likely we will see some form of Statistical Recovery. But we cannot get complacent. Somewhere out there is the real potential for another crisis, which will dwarf the last one. You will not want to be long much of anything when it happens, except hedged or liquid investments. Though admittedly, this could go on for a long time. I just don't know how long "long" is. Other than it will be too long and then not long enough.

Detroit, the Red Sox and the Yankees and Traveling Too Much

I leave for Detroit next Friday and speak at a private conference on Saturday, then rush to the airport to fly to New York. My friend Barry Habib has second-row behind-home-plate tickets to what we hope is a Yankees - Boston Red Sox playoff championship game. That would have to be one of the most exciting games to watch - the emotions will run as high as in any sporting event around. So I find myself in the strange position of cheering on both the Yankees and the Red Sox in the first round of playoffs, and hoping that there is not a four-game sweep in the second.

Dinner with the guys at Yahoo Tech Ticker on Monday, and then an early train to Philadelphia, where I will speak at a conference hosted by my friends and partners at CMG. Dinner that night, a very early flight to Dallas, change airports, fly to Houston to speak at Salient Partners, then a late-night flight back to Dallas, up early to fly to Orlando to be with Jon Sundt of Altegris at the Commonwealth conference, fly back early (sigh) Saturday morning to Dallas, drive home, pack, and take an overnight flight to Buenos Aires to start a speaking tour with new Latin American partner Enrique Fynn, then on to Montevideo, Uruguay, Sao Paulo. and Rio de Janeiro, and then back to Montevideo for a day of R&R. Then back home Monday. I am already tired.

Tomorrow I get to hear Karl Rove (wonder if he will remember me from our Texas days?), Howard Dean, Charles Krauthammer, and a lot of friends, then a series of parties tomorrow night. I always enjoy coming to The Big Easy for this conference. (Note to Chinese and Spanish translators: the Big Easy is a nickname for New Orleans. I can't expect them to know that one.)

It is time to hit the send button, as I have to speak at my next session. You have a great week, and remember that together we will get through all the coming problems. Just keep paying attention.

Your worried about all the unintended consequences analyst,

John Mauldin

Elements of Deflation, Part 2

John Mauldin — Fri, 11 Sep 2009 16:59:00 GMT

Elements of Deflation, Part 2
The Velocity Factor
Y=MV
Sir, I Have Not Yet Begun to Print
There Are No Good Choices
Washington DC, San Diego, and New Orleans, etc.

Just as water is formed by the basic elements hydrogen and oxygen, deflation has its own fundamental components. Last week we started exploring those elements, and this week we continue. I feel that the most fundamental of decisions we face in building investment portfolios is correctly deciding whether we are faced with inflation or deflation in our future. (And I tell you later on when to worry about inflation.) Most investments behave quite differently depending on whether we are in a deflationary or inflationary environment. Get this answer wrong and it could rise up to bite you.

The problem is that there is not an easy answer. In fact, the answer is that it could be both. Today I got another letter from Peter Schiff, who seems to be ubiquitous. He says the rise in gold is because of rising inflation expectations among investors. Gold is predicting inflation. Maybe, but the correlation between gold and inflation for the last 25-plus years has been zero. I rather think that gold is rising in terms of value against most major fiat (paper) currencies because it is seen as a neutral currency. The Fed and the Obama administration seem to be pursuing policies that are dollar-negative, and they give no hint of letting up. The rise in gold above $1,000 does not really tell us anything about the future of inflation.

In fact, it is my belief that if the Fed were to withdraw from the scene of economic battle, the forces of deflation would be felt in short order. The answer to the question "Will we have inflation in our future?" is "You better hope so!"

I wrote in 2003, when Greenspan was holding down rates too long in order to spur the economy, that the best outcome or endgame over the course of the full cycle would be stagflation. I still think that is the most likely scenario. The Fed will fight deflation and knows how to do that. They also know what to do when inflation becomes too high. But there is a cost.

It is not a matter of pain or no pain; it is a matter of choosing which pain we will face and for how long, and perhaps in what order. As I wrote a few weeks ago, like teenagers, we as an economic polity have made some very bad choices. We are now in a scenario where there are no good choices, just less-bad ones.

In a normal world, the amount of monetary and fiscal stimulus we are witnessing would produce inflation in very short order. That is what has the gold bugs of the world excited. It is their moment. They keep repeating that Milton Friedman taught us that inflation was always and everywhere a matter of too much money being printed. The answer to that is that the statement is mostly true, but not always and not everywhere (think Japan). The reality is somewhat more nuanced. Let's review something I wrote last year about the velocity of money, and this time we are going to go into the concept a little more deeply. This is critical to your understanding of what is facing us.

The Velocity Factor

When most of us think of the velocity of money, we think of how fast it goes through our hands. I know at the Mauldin household, with seven kids, it seems like something is always coming up. And what about my business? Travel costs are way, way up; and as aggressive as we are on the budget, expenses always seem to rise. Compliance, legal, and accounting costs are through the roof. I wonder how those costs are accounted for in the Consumer Price Index? About the only way to deal with it, as my old partner from the 1970s Don Moore used to say, is to make up the rise in costs with "excess profits," whatever those are.

Is the Money Supply Growing or Not?

But we are not talking about our personal budgetary woes, gentle reader. Today we tackle an economic concept called the velocity of money, and how it affects the growth of the economy. Let's start with a few charts showing the recent high growth in the money supply that many are alarmed about. The money supply is growing very slowly, alarmingly fast, or just about right, depending upon which monetary measure you use.

First, let's look at the adjusted monetary base, or plain old cash plus bank reserves (remember that fact) held at the Federal Reserve. That is the only part of the money supply the Fed has any real direct control of. Until very recently, there was very little year-over-year growth. The monetary base grew along a rather predictable long-term trend line, with some variance from time to time, but always coming back to the mean.

But in the last few months the monetary base has grown by a staggering amount. And when you see the "J-curve" in the monetary base (which is likely to rise even more!) it does demand an explanation. There are those who suggest this is an indication of a Federal Reserve gone wild and that 2,000-dollar gold and a plummeting dollar are just around the corner. They are looking at that graph and leaping to conclusions. But it is what you don't see that is important.

Now, let's introduce the concept of the velocity of money. Basically, this is the average frequency with which a unit of money is spent. Let's assume a very small economy of just you and me, which has a money supply of $100. I have the $100 and spend it to buy $100 worth of flowers from you. You in turn spend the $100 to buy books from me. We have created $200 of our "gross domestic product" from a money supply of just $100. If we do that transaction every month, in a year we would have $2400 of "GDP" from our $100 monetary base.

So, what that means is that gross domestic product is a function not just of the money supply but how fast the money supply moves through the economy. Stated as an equation, it is Y=MV, where Y is the nominal gross domestic product (not inflation-adjusted here), M is the money supply, and V is the velocity of money. You can solve for V by dividing Y by M.

Now let's dig a little deeper. Y, or nominal GDP, can actually written as Y=PQ, that is, GDP is the Price paid times the total Quantity of goods sold. Therefore, since Y=MV, the equation can be written as MV=PQ. But the point is that Price (P) is tied to the velocity (V) of money. You can increase the supply of money, and if velocity drops you can still see a drop in the "P," or inflation.

Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I am being too simple, wait a few paragraphs, please. Let's assume an island economy with 10 businesses and a money supply of $1,000,000. If each business does approximately $100,000 of business a quarter, then the gross domestic product for the island would be $4,000,000 (4 times the $1,000,000 quarterly production). The velocity of money in that economy is 4.

But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, etc.; and now everyone is doing $100,000 per month. Now our GDP is $12,000,000 and the velocity of money is 12. But we have not increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.

Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing $100,000 a month themselves. GDP potentially goes to $14,000,000. But, in order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Now, this is important. If the velocity of money does NOT increase, that means (in our simple island world) that on average each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity does not increase and money supply stays the same, GDP must stay the same, and the average business (there are now 12) goes from doing $1,200,000 a year down to $1,000,000.

Each business now is doing around $80,000 per month. Overall production on our island is the same, but is divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. They fall into actual deflation (very simplistically speaking). So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

It is basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down, as will the price.

If the central bank increased the money supply too much, you would have too much money chasing too few goods, and inflation would rear its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.)

Let's say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn't it?

No, because only 20% more goods is produced from the two new businesses. There is a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they would spend on goods and services, which only grew by 20%. They would start to bid up the price of the goods they want, and inflation would set in. Think of the 1970s.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let's assume 10 million businesses, from the size of Exxon down to the local dry cleaners, and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month, and another hundred thousand fail. Productivity over time increases, so that we are producing more "stuff" with fewer costly resources.

Now, there is no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy, plus some more for new population, and you have to factor in productivity. If you don't then deflation will appear. But if the money supply grows too much, then you've got inflation.

And what about the velocity of money? Friedman assumed the velocity of money was constant. And it was from about 1950 until 1978 when he was doing his seminal work. But then things changed. Let's look at two charts, the first from Stifel Nicolaus Capital Markets.

Here we see the velocity of money for the last 109 years. The left side of the chart shows the velocity of money using both M2 and M3 (measures of the money supply.)

Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980 the velocity of money was almost exactly the average for the last 100 years. Lacy Hunt, in a conversation that helped me immensely in writing this letter, explained that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War II, but even then mean reversion would mean a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we will see why that is the case from a practical standpoint. But let's look at the first chart.

Y=MV

And then let's go back to our equation, Y=MV. If velocity slows by 30% (which it well has in terms of M3 – and it is down more than 15% in terms of M2) then money supply (M) would have to rise by that percentage just to maintain a static economy. But that assumes you do not have 1% population growth, 2% (or thereabouts) productivity growth, and a target inflation of 2%, which mean M (money supply) would need to grow about 5% a year, even if V were constant. And that is not particularly stimulative, given that we are in recession. And notice in the chart below that M2 has not been growing that much lately, after shooting up in late 2008 as the Fed flooded the market with liquidity.

Bottom line? Expect money-supply growth well north of what the economy could normally tolerate for the next few years. Is that enough? Too much? About right? We won't know for a long time. This will allow armchair economists (and that is most of us) to sit back and Monday morning quarterback for many years.

But this is important. The Fed is going to continue to print money as long as they are not confident deflation is no longer a problem. They can't tell us what that number is because they don't know. My guess is if they did tell us the markets would simply throw up, especially the bond market, which would of course make the situation from a deflation-fighting point of view even worse.

Sir, I Have Not Yet Begun to Print

Remember the story of John Paul Jones? An American naval officer during the American Revolution (the French gave him a medal, although the British referred to him as a pirate), he engaged a larger British ship off the coast Yorkshire. He literally tied his boat to the larger ship and they shot cannons and guns at point blank range. Legend has it that he was asked to surrender, as his ship was sinking. He is supposed to have replied, "Sir, I have not yet begun to fight!"

When faced with the possibility of deflation, I can almost hear Bernanke saying, "Sir, I have not yet begun to print!"

When will they know when enough is enough? When the velocity of money stops falling. When we see two quarters in a row where the velocity of money is rising, then it is time to start investing in inflation hedges.

Now, why is the velocity of money slowing down? Notice the significant real rise in velocity from 1990 through about 1997. Growth in M2 was falling during most of that period, yet the economy was growing. That means that velocity had to have been rising faster than normal. Why? It is financial innovation that spurs above-trend growth in velocity. Primarily because of the financial innovations introduced in the early '90s, like securitizations, CDOs, etc., we saw a significant rise in velocity.

And now we are watching the Great Unwind of financial innovations, as they went to excess and caused a credit crisis. In principle, a CDO or subprime asset-backed security should be a good thing. And in the beginning they were. But then standards got loose, greed kicked in, and Wall Street began to game the system. End of game.

What drove velocity to new highs is no longer part of the equation. The absence of new innovation and the removal of old innovations (even if they were bad innovations, they did help speed things up) are slowing things down. If the money supply had not risen significantly to offset that slowdown in velocity, the economy would already be in a much deeper recession.

The Fed has more room to print money than most of us realize. How much more? My bet is that we'll find out. Will they print too much at some point? Probably.

There Are No Good Choices

What we are looking at in our near future is not inflation. We are in a period where the Fed is in the process of reflating, or at least attempting to do so. They will eventually be successful (though at what cost to the value of the dollar one can only guess). One can have a theoretical argument about whether that is the right thing to do, or whether the Fed should just leave things alone, let the banks fail, etc. I find that a boring and almost pointless argument.

The people in control don't buy Austrian economics. It makes for nice polemics but is never going to be policy. My friend Ron Paul is not going to be allowed to make monetary policy, although he might get a bill through that actually audits the Fed. I am much more interested in learning what the Fed and Congress will actually do and then shaping my portfolio accordingly.

A mentor of mine once told me that the market would do whatever it could to cause the most pain to the most people. One way to do that would be to allow deflation to develop over the next few quarters, thereby probably really hurting gold and other investments, before inflation and then stagflation become (hopefully) the end of our perilous journey. Which of course would be good for gold. If you can hold on in the meantime.

Is it possible that we can find some Goldilocks end to this crisis? That the Fed can find the right mix, and Congress wakes up and puts some fiscal adults in control? All things are possible, but that is not the way I would bet.

While there are some who are very sure of our near future, I for one am not. There are just too damn many variables. Let me give you one scenario that worries me. Congress shows no discipline and lets the budget run through a few more trillion in the next two years. The Fed has been successful in reflating the economy. The bond markets get very nervous, and longer-term rates start to rise. What little recovery we are seeing (this is after the double-dip recession I think we face) is threatened by higher rates in a period of high unemployment.

Does the Fed monetize the debt and bring on real inflation and further destruction of the dollar? Or allow interest rates to rise and once again push us into recession? (A triple dip?) There will be no good choice. The Fed is faced with a dual mandate, unlike other central banks. They are supposed to maintain price equilibrium and also set policy that will encourage full employment. At that point, they will have to choose one over the other. There are no good choices. I can construct a number of scenarios. All end with the same line: there are no good choices.

Washington DC, San Diego, and New Orleans, etc.

It is time to hit the send button. I have struggled through this letter with a very upset stomach. I rarely eat pizza, but my son and his friends ordered and I ate half of a very good pizza with everything, which I very rarely do. It really kicked my gut. Maybe that is why I am a little more bearish than normal tonight.

I fly to Washington, DC on Sunday and will have dinner with good friend Neil Howe (of Fourth Turning fame). I am really looking forward to that. Neil is a very interesting dinner partner. I do some consulting on Monday and then catch a long night flight to San Diego. I will be at the Schwab conference on Tuesday, September 15. If you are going to be there, look me up. I will be at the Altegris booth at the first break and then the Gemini booth with my partners from CMG, where we will be talking about the new mutual fund. (You can learn more about it by reading a report I have prepared, entitled "How to Deal with Volatility in Extraordinary Markets - Introducing the CMG Absolute Return Strategies Fund." Simply click here.) And there will be books there!

That is my only trip in September. But then it gets interesting. I celebrate my 60th birthday the first weekend of October, then fly to New Orleans to be at the annual New Orleans Conference, October 8-11. The speaker line-up is better than ever. I find this to be one of the best conferences I go to very year. I have been attending on and off for over 25 years. You should think about this one. http://www.neworleansconference.com/speaker-eblast-JohnMauldin/

Then I will spend the next weekend in Detroit, then probably go to New York, then Philadelphia for a CMG conference October 20, then down to Houston, over to Orlando, stop to change clothes and pack at home, and then fly off on a whirlwind trip to Argentina, Brazil, and Uruguay, speaking at a series of CFA conferences. Denver and Orlando in mid-November, and nothing else so far. Switzerland and London in January.

Trey came home tonight a little discouraged, with four of his friends. He had been at his first school dance (8th grade). "Dad, I got a Bohac." This is bad. Mr. Bohac is a very reasonable, pleasant enough fellow. However, he is also the vice-principal, and as such is the nemesis of 8th-grade boys. When you get called down for whatever reason, you get what they call a Bohac, which means you have to go to his office. I grimaced. What had he done? A fight? Girls? My mind went through a dozen bad scenarios in about 3 seconds. My stomach, already roiled, immediately got worse.

As it turns out, he simply wore the wrong kind of shorts to the dance. Seems he didn't know the dress code for the dance here in Highland Park. He evidently was not the only one. When he changed and all the kids left the house, I must confess I did not see any difference. Oh well. With any luck, this will be his only Bohac this year. And Dad can live with that.

I'll leave you with this thought I gleaned from a newsletter from Australia called The Privateer (www.the-privateer.com).

"In 1909, the US federal government had an annual budget of $US 0.8 Billion. With this it governed a population of just over 90 million people. The cost of government was about $9 per capita. In 2009, the US federal government has an annual budget of $US 3,550 Billion. With this it governs a population of just over 300 million people. That's a cost of about $11,675 per capita."

Are we 1200 times better off?

Have a great week. With all my flying, I might make it through a few books on my desk this week. I will let you know if anything should be on your radar screen.

Your trying to Muddle Through analyst,

John Mauldin

The Elements of Deflation

John Mauldin — Sat, 05 Sep 2009 04:43:00 GMT

The Elements of Deflation
The Failure of Economics
The Super Trend Puzzle
Final Demand and Income
Unemployment Was NOT a Green Shoot
Washington, DC, San Diego, and Johannesburg

As every school child knows, water is formed by the two elements of hydrogen and oxygen in a very simple formula we all know as H2O. Today we start a series that starts with the question, What are the elements that comprise deflation? Far from being simple, the "equation" for deflation is as complex as that of DNA. And sadly, while the genome project has helped us with great insights into how DNA works, economic analysis is still back in the 1950s when it comes to decoding deflation. Notwithstanding the paucity of understanding we can glean from the dismal science, in this week's letter we will start thinking about the most fundamentally important question of the day: is inflation, or deflation, in our future?

But quickly, I want to thank the many people who wrote very kind words about last week's letter. Many thought it was one of the better letters I have done in a long time. If you did not read it, you can read it here. And of course, you can go there and sign up to get this letter sent to you each week for free. Why not become of my 1 million (plus and growing) closest friends?

The Failure of Economics

Among the economists and writers I regularly read, there are some who, if they agree with me, I go back and check my assumptions - I must have been wrong. Paul Krugman is one of those thinkers. I admit to his brilliance, but his left-leaning philosophy does not particularly square with mine, and I find that most of the time I disagree.

That being said, I strongly encourage you to read his essay in the New York Times Magazine, which comes out this weekend. It is worth the high price of the Times to read it, if you can't get it online. It is a very hard critique and analysis of the failure of current macro and financial economic thought, which didn't even come close to predicting the current financial malaise. Indeed, as he points out, most schools of thought said the state we are in could not happen. You can read at the essay if you are a member, or register for free if you are not. http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?_r=1.

Krugman writes, as I have in repeated columns, that we have taught two generations of economists and financial practitioners faulty theories. Even now, believers in the Efficient Market Hypothesis and CAPM hold to their beliefs in the face of clearly contrary evidence. It is a very thought-provoking piece and worthy of a long weekend read. He names specific names and pulls no punches. This is as close to starting a barroom brawl as you get in economic circles.

He calls for a return to and fresh analysis of Keynesianism. Sigh. I would go further. A plague on all their houses. Whether Keynes or Friedman (monetarism) or von Mises (the Austrian school of economics) or the rather new school of behavioral economics, they all have deficiencies and (sometimes gaping) holes in their logic. At the same time, they all contribute to our general understanding of the world, and there are benefits to studying them.

Let me risk an analogy. It is like reading about some religious scheme for interpreting the world and then becoming a true believer, arguing for that point of view as received wisdom - it's your belief system. Five Nobel laureates say this and seven say that. My guru is smarter than your guru. Look at how the math proves this point. And so on...

Krugman concludes: "So here's what I think economists have to do. First, they have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds. Second, they have to admit - and this will be very hard for the people who giggled and whispered over Keynes - that Keynesian economics remains the best framework we have for making sense of recessions and depressions. Third, they'll have to do their best to incorporate the realities of finance into macroeconomics.

"Many economists will find these changes deeply disturbing. It will be a long time, if ever, before the new, more realistic approaches to finance and macroeconomics offer the same kind of clarity, completeness and sheer beauty that characterizes the full neoclassical approach. To some economists that will be a reason to cling to neoclassicism, despite its utter failure to make sense of the greatest economic crisis in three generations. This seems, however, like a good time to recall the words of H. L. Mencken: 'There is always an easy solution to every human problem - neat, plausible and wrong.'"

I agree we need to examine our assumptions. I am not sure that makes me want to unreservedly embrace Keynes. Keynesians missed as badly as anyone else in this crisis. Yes, the Austrians generally called some of the problem, but their solutions call for 25% unemployment and an unworkable global economy and a serious depression. Not sure that I want to sign up for that, either. And, they totally discount the concept of the velocity of money, which we will look at next week.

We need a new and better economic understanding, not some semireligious adherence to dogma laid down by men who were in no way familiar with current world conditions. Keynes, von Mises, Fisher, Schumpeter, Minsky, Hayek, Smith, et al. were giants. They absolutely must be read and understood. But a real science builds on the work of the former generations and does not hold onto theories as if they were scripture.

As much as many economists would like to think so, economics is not a precise science. A global economy cannot yield to hard math in the way that one can model a protein, at least not with any model that has yet been offered. At best, the models let us see through a glass darkly, suggesting the potential for connections between a few variables, while assuming that all others are held constant. It is precisely the illusion that we can model the economy that got us into the current mess.

(By the way, good friend Paul McCulley has written a very interesting essay on why the Fed has to change their models on inflation targeting - the Taylor Rule is not up to the task - and whether or not to deal with bubbles before the fact, rather than mopping up after they burst. What was assumed has clearly not worked. You can read it at www.pimco.com.)

I am often asked what school of economic thought I adhere to, and the answer is, none. I would rather try to get it right. And rather than argue for one policy or another (which admittedly I sometimes do), it is more important to figure out what those who actually will effect policy will do, and then make sure we are not in the way of the train they are sending down the tracks. Agree with Krugman or not, he is one of the principal conductors on the train.

And that brings us back to the elements of deflation.

The Super-Trend Puzzle

I am a big fan of puzzles of all kinds, especially picture puzzles. I love to figure out how the pieces fit together and watch the picture emerge, and have spent many an enjoyable hour at the table struggling to find the missing piece that helps connect the patterns.

Perhaps that explains my fascination with economics and investing, as there are no greater puzzles (except possibly the great theological conundrums or the mind of a woman, about which I have only a few clues).

The great problem with the economic puzzles is that the shapes of the pieces can and will change as they rub against one another. One often finds that fitting two pieces together changes the way they meld with the other pieces you thought were already nailed down, which may of course change the pieces with which they are adjoined, and suddenly your neat economic picture no longer looks anything like the real world.

(Which is why all of the mathematical models make assumptions about variables that allow the models to work, except that what they end up showing is not related to the real world, which is not composed of static variables.)

There are two types of major economic puzzle pieces. The first are those pieces that represent trends that are inexorable: they will not themselves change, or if they do it will be slowly; but they will force every puzzle piece that touches them to shift, due to the force of their power. Demographic shifts or technology improvements over the long run would be examples of this type of puzzle piece.

The second type is what I think of as "balancing trends," or trends that are not inevitable but which, if they come about, will have significant implications. If you place that piece into the puzzle, it too changes the shape of all the pieces of the puzzle around it. And in the economic super-trend puzzle, it can change the shape of other pieces in ways that are not clear.

Deflation is in the latter category. I have often quipped that when you become a Federal Reserve Bank governor, you are taken into a back room and are given a DNA change that makes you viscerally and at all times opposed to deflation. Deflation is a major economic game changer. You can argue, as Gary Shilling does, that there is a good kind of deflation, where rising productivity and other such good things produces a general fall in prices, such as we had in the late 19^th century.

But that is not the kind of deflation we face today. We face the deflation of the Depression era, and central bankers of the world are united in opposition. As McCulley quipped to me this spring, when I asked him if he was concerned about inflation, with all the stimulus and printing of money we were facing, "John," he said, "you better hope they can cause some inflation." And he is right. If we don't have a problem with inflation in the future, we are going to have far worse problems to deal with.

Saint Milton Friedman taught us that inflation is always and everywhere a monetary phenomenon. That is, if the central bank prints too much money, inflation will ensue. And that is true, up to a point. A central bank, by printing too much money, can bring about inflation and destroy a currency, all things being equal. But that is the tricky part of that equation, because not all things are equal. The pieces of the puzzle can change shape. When the elements of deflation combine in the right order, the central bank can print a boatload of money without bringing about inflation. And we may now be watching that combination come about.

Final Demand and Income

For instance, inflation always seems to be accompanied by higher wages. That makes sense, as workers want more to justify their labor if prices are rising. But today we have wages dropping over time. Yes, even though wages went up this month by 0.3%, it was all due to a one-time increase in the minimum wage. Without that government mandate wages would have been flat or falling. Look for wages to fall over the rest of the year.

There are no pricing pressures on wages. Look at this very eye-opening graph from my friends at one of my must-read letters, The Liscio Report. (www.theliscioreport.com).

Throughout the last decade, the number of strikes involving a thousand or more workers averaged about 22 (but averaged over 300 annually from the time they started tracking this item). We are on target this year for 2, an amazing 62-year low. Indeed, we have the opposite happening. Workers are seeing jobs lost, wages being slashed, hours being cut back, and a loss of benefits, as businesses react with cost cuts to the lack of demand.

While it is technically possible to have inflation with rising unemployment and falling wages, it would take a great deal of monetization to achieve, and that will bring us to a new idea in a few paragraphs.

Unemployment Was NOT a Green Shoot

But quickly, let's look at today's unemployment numbers. This was not the way one would want to celebrate Labor Day. Unemployment rose to 9.7%. Some take comfort in that unemployment in the Establishment Survey (where they call existing business and poll them) was only down by 216,000, which admittedly is better than 600,000 but is still a very bad number. Rising unemployment is not the stuff that inflation is typically made of. And there are reasons to think the picture may be worse than that. Here are a few thoughts from David Rosenberg:

"What was really key were the details of the Household Survey, which provide a rather alarming picture of what is happening in the labor market.

"First, employment in this survey showed a plunge of 392,000, but that number was flattered by a surge in self-employment (whether these newly minted consultants were making any money is another story) as wage & salary workers (the ones that work at companies, big and small) plunged 637,000 — the largest decline since March (when the stock market was testing its lows for the cycle). As an aside, the Bureau of Labor Statistics also publishes a number from the Household survey that is comparable to the nonfarm survey (dubbed the population and payroll-adjusted Household number), and on this basis, employment sank — brace yourself — by over 1 million, which is unprecedented. We shall see if the nattering nabobs of positivity discuss that particularly statistic in their post-payroll assessments; we are not exactly holding our breath."

The ISM numbers came out this week and, while manufacturing is up, the service industry (which is far larger) is still contracting, and the employment elements in the surveys show employers are still planning to cut jobs. Think about almost 11% unemployment next summer in the middle of the political season. Watch the competition among politicians to demonstrate they care and "get it." And watch as they spend your money to show how much they care.

And from the above mentioned Liscio Report: "As we outlined back in May, financial crises hammer employment, resulting in average losses of 6.3% followed by a long flat line. We hate to point it out, but we're currently down 4.8% from the December 2007 onset, and if US job losses in this recession stay in line with the major financial recessions in "advanced" countries studied by the IMF, we stand to lose another 1.8 million jobs. Some of those will likely be taken out in upcoming benchmarks, stimulus money has some clout, and no one has a reliable crystal ball, but we need to remember where we are in a painful cycle if we see some hopeful flickers."

That would take us to well over 11% unemployment.

Interesting statistic. Want to know where wages are rising? Think federal government workers. The gap between civilian and government workers was less than $13,000 nine years ago, but now is almost $30,000. Inflation has been 24%, but government wages are up 55%. According to a recent release from Rasmussen Reports, a government job remains "the top employment choice in today's economic environment." (chart from Clusterstock)

States, counties, and cities are having to make deep cuts, in both jobs and programs. Today's Wall Street Journal talks about the cuts in state after state. States cannot print money like the US can, so at some point they have to either raise taxes or cut spending to balance their budgets. Raising taxes just makes it less profitable for businesses to remain in your state. There is a very high correlation with high state taxes and unemployment.

The following chart shows how rapidly income taxes are falling. Sales tax receipts are down. At some point voters are going to demand that their federal government show some of the same restraint that households, cities, and counties are being forced into. My bet is that next year raises for government workers, even those in unions, will come under attack. They won't be cut, but watch as political backlash builds.

Without federal stimulus, the GDP of the US would have been over minus 6% in the second quarter, not the minus 1% it was. The third quarter would be flat to down and not the plus 3% it is likely to be. Housing and autos will turn down as the stimulus on those markets goes away.

I think it is very possible we will see a negative GDP by the first quarter of next year. Unemployment will still be rising. Deflation will be more of a problem, because the housing component (the largest portion of the consumer-inflation index), based roughly on rentals, is clearly under pressure. While we don't have enough space this week to go into detail, savings are up and consumer spending is down. Without the stimulus, things would be much worse.

Here's the kicker. Expect to see a big push for another large stimulus package next spring (and maybe sooner), as the effects of the current one wear off. The government wants to bring back demand by getting consumers to spend again. And you can count on unemployment benefits being extended. A tax holiday on Social Security taxes below a certain income? In the short run they can do it, but at a long-run cost.

It is going to be hard for a Democratic administration to not push for another large stimulus. That is what Krugman and his fellow travelers will be pushing. Classic Keynesian thinking wants both for the government to run large deficits and for the central bank to print more money. Remember, last year I said that the Fed would print a lot more money than they are talking about in the current plans. They are going to have the cover to do so, because deflation is going to be seen as the problem.

Next week, we will look at money supply and the velocity of money, savings, consumer demand, and more as we further explore the complex molecule that is deflation.

But one last thought, as I have had a lot of questions on gold recently. "Isn't gold telling us that inflation is coming back?" The answer is no. Since the early '80s the correlation between gold and inflation has dropped to zero. Gold has had very little to say in the last 30 years about inflation.

But what it may be saying is that paper currencies are a problem. Gold is going up not only in dollar terms, but in euros, pounds, yen, and more. My view is that gold should be seen as a neutral currency. The dollar is the worst currency in the world, except for all the others. Is it possible the Fed will not respond and print more money next year? Sure. And the dollar could rise as deflation kicks in. The only time we saw the purchasing power of the dollar rise in a sustained manner was during deflation, in the last century.

The race is not always to the swiftest or the fight to the strongest, but that's the way to bet. And right now, my bet is the Fed will print money to fight a double-dip recession and deflation. And gold would be one way to play that bet.

Washington, DC, San Diego, and Johannesburg

Quick inside industry note: Many RIA and brokers have left some of the large brokerage firms to go with smaller broker dealers or start up as independent investment advisors. Some of the larger firms had platforms that accessed the world's top hedge-fund managers. Now that the advisors are independent, they are looking for a similar platform.

Altegris Investments has a world-class lineup of top-tier hedge-fund managers that advisors can access for their clients at much lower minimums. Altegris employs 65 people and has over $2 billion under management. They focus solely on alternative investments. They have 10 staff members dedicated to research and due diligence on the hedge-fund universe. I know Jon Sundt (CEO of Altegris) personally and I know that he is driven to find the best investment talent in the world. If you are an advisor for high-net worth-clients, you should go to www.accreditedinvestor.ws and sign up and they will call you.

And if your clientele consists mostly of smaller clients, you should look at the platform of trading advisors at CMG. http://cmgfunds.net/public/mauldin_questionnaire.asp

Next week I have to go to Washington, DC for a quick trip and then the next night fly to San Diego for the Schwab conference. Coincidentally, both Altegris and CMG will be at the conference. I will be around those booths on Tuesday the 15th. Look me up.

And next Tuesday I will speak via satellite to a CFA conference in Johannesburg. I've done a lot of TV over satellite, but not a full, hour-long speech and Q and A. This should prove interesting.

It is getting late and time to hit the send button, so I will cut my remarks short and just wish you a happy Labor Day and a great week.

Your ready for a holiday analyst,

John Mauldin

The Statistical Recovery, Part Three

John Mauldin — Sat, 22 Aug 2009 04:00:00 GMT

The Statistical Recovery, Part Three
Capacity Utilization Set to Rise
A Real Estate Green Shoot?
The Deleveraging Society
Some Thoughts on Secular Bear Markets
Weddings and Ten Years of Thoughts From the Frontline

This week we further explore why this recovery will be a Statistical Recovery, or one that, as someone said, is a recovery only a statistician could love. We look at capacity utilization, more on housing, some thoughts on debt and deflation, and some intriguing charts on volatility in the last secular bear-market cycle. This letter will print a little longer, but there are lots of charts. I have written this during the week, and I finish it here in Tulsa, where Amanda gets married tomorrow. (There is no deflation in weddings costs!)

Thanks to so many of you for your enthusiastic feedback about my latest Accredited Investor Newsletter, in which I undertook to examine the impact of last year's dramatic increase in volatility on the performance of hedge funds and to ascertain those elements that led to success in the industry, such as select Global Macro and Managed Futures strategies, as well as the challenges. If you are an accredited investor (basically anywhere in the world, as I have partners in Europe, Canada, Africa, and Latin America) and haven't yet read my analysis, I invite you to sign up here: www.accreditedinvestor.ws

For those of you who seek to take advantage of these themes and the developments I write about each week, let me again mention my good friend Jon Sundt at Altegris Investments, who is my US partner. Jon and his team have recently added some of the more successful names in the industry to their dedicated platform of alternative investments, including commodity pools, hedge funds, and managed futures accounts. Certain products that Altegris makes available on its platform access award-winning managers, and are designed to facilitate access for qualified and suitable readers at sometimes lower investment minimums than is normally required (though the net-worth requirements are still the same).

If you haven't spoken with them in a while, it's worth checking out their new lineup of world-class managers. Jon also tells me they just added yet more brilliant minds to their research team, making it, in my opinion, one of the foremost teams in the industry, focused solely on alternative investments. I invite you to have a conversation with one of their professional and seasoned advisors. (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member FINRA.) Now, let's jump into the Statistical Recovery.

Capacity Utilization Set to Rise

Capacity utilization is a concept in economics that refers to the extent to which an enterprise or a nation actually uses its installed productive capacity. Thus, it refers to the relationship between actual output that is produced with the installed equipment and the potential output that could be produced with it, if capacity was fully used.

The chart below shows that capacity utilization in the US is at an all-time low, around 68%. That means that with the equipment we already have in place we could produce almost 50% more goods than we are now producing. However, most analysts think that 80% capacity utilization is a very good number.

If you look very closely at the bottom right-hand detail, you can see that there is a small uptick in last month's data. Whether or not this is the "bottom" remains to be seen. But if it is not the bottom, it is close. You can only shut down so much production before inventories fall to levels that require restocking. And we are getting close to that level in many industries.

Before we wander too far away from the graph, I want you to notice that past dips (circa the recessions of 1968, '74, and '80-'82) had V-shaped recoveries in capacity utilization. But in the 1990-91 recession it took longer than it did in past recessions, and in the most recent recession (2000-02) the recovery took longer and we did not actually "recover" for four years.

Again, most analysts feel that a capacity utilization of 80% or more is pretty indicative of solid growth. To get back to that level, we would have to see an almost 20% rise in manufacturing. That is unlikely to happen all that fast, for several reasons.

First, consumers are retrenching and saving. We just simply are not going to need or want as much stuff. Second, unemployment, as I noted last week, is crimping the ability of consumers to spend. The recovery we are likely to see is going to be sluggish and not produce new jobs for quite some time. Again, that stifles demand.

The country (and the world) is adjusting to the New Normal. It is some level of overall economic activity that is different than what we have enjoyed during the reigning paradigm of the last 30 years.

Manufacturers are going to ramp up more slowly than in the past, especially as many companies have the ability to tailor their production to consumer demand much faster now, due to automation.

As I have repeatedly said, the world is awash in excess capacity. We simply built too much productive capacity to be utilized in the New Normal. One way of dealing with too much capacity is to simply close the plants. That is what is happening in the paper and memory-chip industries. Other industries are engaging in mergers to reduce or "rationalize" capacity. While that process is a good thing, it does mean that unemployment rises or stays higher longer.

The building of inventories counts as a rise in GDP. Conversely, reducing inventories gets counted as a lack of growth. We have just about reduced inventories all we can. As companies begin to rebuild inventories, that will translate into a statistical increase in GDP. But if capacity utilization is still only (say) 73%, it still shows a weak economy with not many new jobs and reduced corporate profits, compared to a few years ago. It will be a rather long time before the jobs that have been lost this cycle will come back. Will the statistical comparison of data from a year ago look positive? Are things improving? The answer will be yes. But it will not feel like it for those who are looking for new jobs or higher income or more sales.

Look at it this way. We have dug ourselves into a 12-foot hole over the past two years. The data now suggests that we have stopped digging, which is always a good idea if you are in a hole. At some point we will have figured out how to add some dirt to the bottom to get us back up to an 8-foot hole. Will we be better off statistically? Absolutely. But we will still be in a hole. Unemployment falling back to 8% in 2011 will still feel like we are in a hole, but the statistics will say GDP is positive. And that is because we are so far down, the year-over-year comparisons are starting to look good.

As an aside, it would be highly unusual for inflation to show up with low capacity utilization and rising unemployment. Businesses and workers simply do not have pricing power.

A Real Estate Green Shoot?

The housing news has been less bad of late. Home-builder sentiment is marginally higher. Today we learn that sales are up month-over-month, and actually year-over-year, on a seasonally adjusted basis, which is some of the best news on the housing front we have had in two years. Sales of existing homes were the highest since August of 2007. Have we seen the bottom? The following chart shows that while actual homebuilding activity is still down, the annual comparisons are getting easier and activity seems to be leveling out.

Note, however, that this is yet another aspect of the Statistical Recovery. For two years, the continual drop in home building reduced the GDP numbers every quarter. If homebuilding activity simply stops falling, as it appears to be, then housing will stop being a negative as far as GDP is concerned. Will we get back to the levels of 2005? Not for many decades and with a much larger population. We are now finding the New Normal as far as home construction is concerned.

And before we get too celebratory, my friend John Burns of John Burns Real Estate Consulting suggests we may be seeing a false bottom. What we are seeing is the result of a government program that offers first-time home buyers $8,000 if they buy a home by November 30; and that program is working, especially at the lower end of home prices (as you would expect, and as it should.) 31% of home sales in July were involved with this program. But like Cash for Clunkers in automobiles, this is pushing demand for homes from next year into this year.

John offers us the following chart that gives us what he thinks is happening in the markets, from his surveys. He thinks that we saw a "false bottom" in April of this year and that activity will peak in November, before going on to the actual bottom, from which there will be a long, slow recovery.

There are millions of homes being brought onto the market through foreclosures -- two million vacant homes for sale, plus, builders are still building. It will simply take some time to work through the inventory.

There are some who wonder why home builders keep building if inventories are so high. First, for many of the larger public companies, to stop activity altogether would be commercial suicide. You can't just stop without dying. Further, many of them have financial commitments that require them to build in order to make something to pay back the loans, even if they lose money. Maybe they won't build McMansions or in Florida, but they will find out what will sell and where and build there. Smaller builders have the option of not building "spec" homes (homes built without a buyer already lined up, that is, on speculation). Like my neighbor who just tore his house down this week (can they ever do that fast!) and plans to build a large new home, much of the home activity will be pre-sold for the next few years. (I can't tell you how much I look forward to the sound of hammers and saws next door as I write and read.)

The Deleveraging Society

My friend Ian McAvity offers us the following chart, which shows the level of total debt to GDP. It has been rising steadily since 1981 and is now at a ratio of 3.75. Even though consumers and businesses are cutting back on borrowing, the US government is more than making up the difference; so for awhile, at least, we will see total debt to GDP continue to rise. Side note: even with all the money the Fed is printing, M-1 is flat for the last year.

One of the drivers of the growth of the last 30 years has been financial innovation and the ability to increase leverage. Specifically, securitization made it possible to finance a whole array of debt, from credit cards, student loans, and auto loans, to exotic residential mortgages of all kinds, commercial mortgages, corporate bonds, hotel financing, and regular bank loans that were spun out into SIVs and off the banks' books, thereby freeing up capital – and on and on. If it moved, someone could (and did) figure out how to get it into a security and sell it. And it was easy to sell as long as it had a rating from an established rating agency.

Much of this securitization is plain vanilla and a very good thing, as it gives investors a way to get more fixed income. But the rating agencies started using models that were obviously flawed to create the ratings. Massively flawed. Incompetence immortalized in a spreadsheet. When I and others began to write about the problems with CDOs and CDOs squared in 2006, they continued to rate them with the same flawed models. Even when the rules for getting a mortgage changed, they did not change their models. And it isn't that they couldn't have been aware. The TV was rife with ads talking about the various mortgages available, yet the rating agencies used models based on completely different types of mortgages.

And now? If you are sitting at the fixed-income desk at a pension or insurance fund, it is worth your job to take the word of a rating agency. Therefore, securitization is moribund. Will it come back? Yes. But it will take time.

But that is the problem. The world of finance is going to its own New Normal. It will be a world that is less leveraged. The growth in leverage that helped spur growth on the way up is a drag on growth as it is wound down.

Again, it would be highly unusual to see inflation in a deleveraging world. It would be a massive failure on the part of the Fed to allow serious inflation (as in the 1970s) to come back to the levels that some are talking about. I mean, it's possible, but it's far from the most likely outcome.

I had this conversation with Paul McCulley earlier in the year, as we were all deep in the deflation/inflation discussion. He looked at me and said, "John, we better hope the Fed can create some inflation. If they can't, we're in real trouble."

I will write about the current lack of inflation and its future prospects in a future letter; but producer price indexes are way down all over the world, and the CPI (consumer price index) is down year-over-year.

The single most important question for investors to get right over the next few years is whether we face an inflationary or deflationary future. And while there are many who are so positive that they know the answer, and we find people arguing all sides of the issue, I am not persuaded that we have the information we need to make that determination. It could go several ways. My best guess (hope?) is that we get through this bout of deflation and have to deal with some mild, 3-4 % real inflation, not the commodity price-driven kind, which is not monetary inflation. But this will be a multi-year cycle. I will be writing about this for a long time.

Some Thoughts on Secular Bear Markets

Yesterday my good friend Ed Easterling dropped by, as he was in Dallas, down from Portland. Ed co-authored a few chapters with me in Bull's Eye Investing, on secular market cycles. He had a chart that I asked him to get to me for your perusal. The last secular bear market was 1966-82. He charted the ups and down in that market and noted the percentage rises and falls. It was as volatile then as it is now. There were some breathtaking ups and downs. With every rise, pundits declared the end of the bear market, only to have the market fall dramatically again. Take a few moments to gaze at the chart:

What drives the volatility? My contention is that bull and bear cycles should be seen in terms of valuation instead of price. Markets go from high valuations to low valuations and back to high. It is an age-old story. We have done about half the work we need to do to get back to low valuations. These cycles average of 17 years. We are less than ten years into this one.

I believe we are going to lower valuations in terms of price-to-earnings ratios. This can be done by the market going sideways and earnings rising, or the market dropping, or some combination. Look at the graph below, and notice the slow and steady drop in P/E ratios (bottom chart) and the very volatile markets that accompanied that fall. I agree with Ed; we should not be surprised at today's volatile markets. And we should expect more volatility and large price movements. Both up and down. (Some of the best charts anywhere are at www.crestmontresearch.com.)

Weddings and Ten Years of Thoughts From the Frontline

This month starts my tenth year of writing Thoughts from the Frontline. I started the letter in August of 2000 with less than 2,000 readers. Every letter since January, 2001 is in the archives. The letter now goes to well over one million readers each week, plus is posted on dozens of independent web sites. I am somewhat overwhelmed at the response, but am very grateful. I can honestly say that I am having more fun today than at any time in my life. Thank you for being part of it all.

I have written this letter in airports, hotels, airplanes, cars (I am finishing this one in a car, riding to the rehearsal dinner for my daughter's wedding) and today wrote a lot at the Golf Club of Oklahoma, waiting for the wedding rehearsal. (First time writing in a golf club ... and now I'm about to walk into Dave and Buster's, where I'll wrap this up.)

It is going to be a beautiful wedding, outdoors with beautiful lake views, and the weather is slated to be perfect. We played golf today with the new inlaws, and surprisingly, the weather was pleasant for Tulsa in August. I fought the course and the course won.

Tomorrow is a late brunch with all the guys and then we go to watch Inglorious Basterds, which I have been waiting for for a long time. Good movie for a testosterone-laden crowd.

It is a little sentimental this weekend. My second daughter (Amanda) getting married. All the kids in one place. New grandson Caleb here. Tiffani (girl) and Chad's SO Dominique (another boy) very pregnant. New boyfriends here and there. 60 years looking at me in a few weeks. And thinking about how time just is flying by. How could it be nine years of writing every week to my closest friends?

It is time to hit the send button. I am sitting at the table with all my kids. They know Dad has to finish, but are tolerant. Have a great week. And remember that valuations, when it come to family and friends, only climb higher as time passes.

Your really happy with life analyst,

John Mauldin

The Statistical Recovery, Part 2

John Mauldin — Sat, 15 Aug 2009 00:49:00 GMT

The Statistical Recovery, Part Two
A Recovery Statisticians Can Love
A Few Thoughts on the Housing Market
Some Thoughts from Maine
Tulsa, Birthdays, Weddings, and Paul McCartney

A few weeks ago I first used the term "statistical recovery" to describe the nature of today's economic environment. Today we are going to further explore that concept, as it is important to have a real understanding of what is happening. This coming "recovery" is not going to feel like a typical one, and those expecting a "V"-shaped recovery are simply making projections from previous economic recoveries, which, based on the fundamentals, are not warranted. And of course, a few thoughts coming back from Maine are in order. There is a lot to cover, and this may take more than one letter.

But first, let me note to subscribers to Conversations with John Mauldin that we have posted my Conversation with George Friedman of Stratfor and will soon post a very interesting Conversation I had with John Burns (of John Burns Real Estate Consulting) and Rick Sharga of RealtyTrac. These may be the two most knowledgeable people on the housing market in the country. There is a lot of poorly informed speculation about the housing market, and I think this Conversation will help clear away a lot of the fog. PLUS, they both agreed to allow me to post their eye-opening PowerPoint stacks to Conversation subscribers (normally only available to their clients), so you get a very special bonus. And finally, David Galland of Casey Research is allowing me to post a most thought-provoking interview he did with Neil Howe. This is one of the best things I have run across in a long time. I do work on giving my Conversations subscribers good value.

George and I are going to be doing a regular quarterly Conversation called Geopolitical Conversations with John Mauldin and George Friedman. We believe that these new Conversations will help you better understand not only the global political landscape but also how it affects the financial umbrella that we are under. In this first Conversation, we talked about the "exogenous" risks to the markets (those from outside the markets themselves) posed by the geopolitical world.

We will offer this service, which will be priced separately, at some point in the near future. Now, here is the important part: all current subscribers and anyone who subscribes now will receive these Geopolitical Conversations free, as a thank you. (Current members can log in now.) If you have not yet subscribed, you can do so and receive a discount by clicking the link and typing in the code JM47 to subscribe for $149. This is a large discount from our regular price of $199; plus, we are including the bonus Geopolitical Conversations that are worth $59. And now, to the regular letter.

The Statistical Recovery

The unemployment numbers came out last Friday, and Steve Liesman of CNBC did several interviews live from Leen's Lodge in Maine. I postponed an hour of fishing to be on air with Martin Barnes (of the Bank Credit Analyst) to comment on the numbers. Everyone seemed quite excited that the US lost "only" 247,000 jobs. However, it is still almost twice as large as a year ago, and at that time 128,000 lost jobs seemed pretty bleak. However, comparing it to the average of 692,000 lost jobs per month in the first quarter, those looking for good news immediately started talking about how a recovery is around the corner.

The unemployment numbers are some of the most seriously revised numbers in all of government data. The first monthly estimate is notoriously imprecise. Why people make investment decisions based on this release is beyond me. As I mention continuously, because of seasonal adjustment factors, the unemployment numbers understate job losses in a recession and also understate job gains in a recovery. About the most we can get from the current data is the broad trend. Admittedly, the trend is getting better, but we are still in a hole and no one has stopped digging.

What we can see is that we are down 6.7 million jobs since the beginning of 2008! We have roughly eliminated the job growth of the last five years. And that does not take into account the 150,000 new jobs that are needed each month just to maintain the employment rate because of the increase in population. It took 55 months once the 2001 recession was officially over to get back to the previous employment peak. That is 4.5 years, gentle reader, and we are further down now and faced with massive deleveraging. It is going to take a lot longer this time. Let's look at some of the reasons why.

I took a different tack in the CNBC interview. I pointed out that even though it is possible (likely?) we will see a positive number for GDP for the third quarter, it is not going to feel like a recovery for quite some time.

By the middle of next year (2010), when I think we will finally hit an unemployment bottom, we will be down close to 8 million jobs, wiping out all the jobs created since the middle of 2004. Unemployment is likely to be more than 10%, unless they keep playing games with the number.

A Recovery Statisticians Can Love

What I mean by that remark is that the unemployment number went down even though we lost 247,000 jobs. How can that be, you ask? Well, the government assumes that if you were not looking for a job within the last month, then you are not unemployed; therefore, on a statistical basis the number of people unemployed went down by 400,000. (There are 2.3 million such discouraged workers.) More in a minute on the problem that will cause down the road.

Assume that we will need 9 million jobs over the next five years (150, 000 jobs a month for 60 months) and add the 8 million lost jobs. That means we have to add 17 million jobs in the next five years to get back to the 4.5% unemployment of 2007, let alone the under-4% we saw in 2000.

That means we need to grow employment by about 12% over the next five years. But it's worse than that. What is known as U-6 unemployment is over 16%. There are another approximately 8.8 million people who are either working part-time but want full-time jobs or are among the 2.3 million discouraged workers as mentioned above.

(The definition of U-6 unemployment from the BLS web site: "Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. Discouraged workers, a subset of the marginally attached, have given a job-market related reason for not looking currently for a job. Persons employed part time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule." http://www.bls.gov/news.release/empsit.t12.htm.)

Let's make the assumption that the part-time workers want to go to full-time (which they say they do). Typically employers will increase the hours of part-time employees before adding new workers. That will be a major drag on potential job growth. It is the equivalent of creating at least 4 million jobs, except that no new jobs are created. Plus, those who want jobs but are not looking will come back into the market if jobs are available. That adds another 2 million. Now we are seeing the need for 23 million new jobs in five years, to get back to the "Old Normal."

That is an increase of 15% total employment from today's levels over the next five years. That type of jobs growth will only happen with significant economic growth. Normally, you should expect the economy to rebound to at least 3% trend GDP growth. That is what has happened historically. But we are not in the Old Normal. We are entering the era of the New Normal, where looking back at historical trends will prove to be misleading at best.

On average, and VERY roughly, you would think you would need a minimum of 15% real GDP growth over five years to get us back to what we think of as acceptable levels of unemployment. Actually you would need more, as productivity growth lessens the need for more workers. Oh, and add in the Boomer-generation workers who are not going to retire because they now cannot afford to.

(I think we will be lucky to have 10% real GDP growth in the next five years, for a host of structural reasons that we will be going into below and over the next few weeks.)

Unemployment will be rising for at least another two quarters and probably through the middle of next year. That should not surprise us too much, as unemployment kept rising for almost two years after the last recession, which many dubbed "the jobless recovery." The recession ended in 2001, but as the graph below shows, the unemployment rate rose until the middle of 2003.

We may have a "statistical recovery." The numbers may be positive for a variety of reasons only a statistician could love, but it is not going to feel like a recovery to the rest of us. Maybe that is why consumer confidence took another hit today, dropping to its lowest level since March, helping to drive the market down.

The economists at economy.com, who normally have a bullish tinge to their writing, said it succinctly: "Confidence will struggle to gain ground in the months to come, as consumer budgets remain stretched. Little wage income, prospects for reduced bonus payments, reduced access to credit, and no capital gains are all constraining consumers' ability to meet their financial needs and recover from the sharp drops in wealth they have experienced. Many consumers are struggling to pay their debts. Supports are coming from reduced layoffs, equity market gains, and stimulus such as the cash for clunkers program, but that is proving inadequate to lift spirits so far. It will likely be some time before conditions turn enough for confidence to improve decisively. Key drivers of confidence include developments in the labor and housing markets and the path of energy and equity prices."

(My friend Bill Bonner described the Statistical Recovery as being just like a female impersonator. He is just like a real woman in every way, except for the essential ones.)

The consumer's sense of discomfort is shared in executive suites across the country. "Chief Executive Magazine's CEO Index, the nation's only monthly CEO Index, dropped to 63 in July, after showing gradual improvement. All components of the index are down, with Employment Confidence taking the largest hit...

"What's worse is that pessimism over employment is reaching new heights. The Employment Confidence Index declined 25 percent with 57 percent of CEOs expecting continued decrease in employment next quarter. Over 95 percent rate the current employment environment as bad—the highest level for 2009. Less than 5 percent think employment conditions are normal and virtually no one (0.4 percent) thinks they are good." (The Bill King Report)

A Few Thoughts on the Housing Market

Bill also sent me a link to a very interesting survey of the real estate market. Those in the real estate business will find this of value, although it makes for grim reading. (http://www.campbellsurveys.com/AgentSummaryReports/AgentSurveyReportSummary-June2009.pdf)

Three (of the sixteen) of their summary bullet points stood out:

The market for home purchases can be divided into segments of 26% for damaged REO, 23% for move-in ready REO, 14% for short sales, and [only!] 36% for non-distressed properties. [REO means "real estate owned," typically by a bank as a result of a foreclosure.]
43% of homebuyers are first-time homebuyers, 29% are current homeowners (relocation or retirement homes), and another 29% are investors.
Only 31% of non-REO home sale listings are unforced or optional; other major reasons for listings include financial stress (including short sales), long distance relocation, and divorce or estate sales.

Think about that for a minute. Two-thirds of home sales are either foreclosures or banks taking a loss on the mortgage. Of the remaining 36%, only 10% are as a result of something we could call a normal selling process. And that is nationwide. There are lots of places where foreclosures are low. Reading this report anecdotally, there are large areas (California, Nevada, Arizona, Florida) where almost the only housing action is distressed or forced sales, that is, sales at a significant discount to original asking price.

Look at the chart below from Rick Sharga at RealtyTrac. Today we learned from them that foreclosures set a new monthly record of 360,149 properties that received a default or auction notice or were seized last month. One in 355 households got a filing, the highest monthly rate in RealtyTrac records. Many hard-hit areas have rates higher than 1 in 39 homes! Foreclosures are now running about six times higher than just four years ago.

And there is little relief in sight. There is typically about one foreclosure for every 6-10 jobs lost. It will be higher this cycle, as so many homebuyers are underwater on their mortgages and have little incentive to try and keep up payments while they are unemployed. Further, there are 500,000 REO-owned homes that are not on the market as of yet (what Sharga calls shadow inventory), and a wave of foreclosures will result from option ARMs and Alt-A loans resetting next year. Note: July's record numbers are not in the chart below.

John Burns gives us the next graph, which is an estimate of foreclosures for the coming years. (www.realestateconsulting.com)

Notice that he estimates more foreclosures next year than this year, with very little relief until 2014! This does not bode well for housing prices, which are a big factor in consumer sentiment, which is a big factor in consumer spending.

It does mean that renters can find some very good deals, as there are now areas (like Phoenix) where it is cheaper to buy smaller homes than to rent. Remember the statistic above that first-time home buyers are 43% of the market and investors another 29%? Lower prices make housing more affordable, and with the government incentive programs for first-time buyers really working (for once), the lower end of the housing market may actually stabilize sooner than the overall market.

As I wrote almost two years ago, the housing market will not bottom before 2011 and maybe into 2012. We just built way too many homes in our exuberance; and with tightening lending standards (as there should be) the number of people who can qualify for a mortgage is down, although (again) falling prices make homes more affordable. The median price in California is down by 60%. (Although I saw today where Bill Gross bought a tear-down on the water in Newport Beach for $23 million. That will help the average some.)

Homeowner vacancy rates are close to 3% of total homes, which is well over 2 million homes. Many of these are not yet on the market.

Retail sales were down in July. And that was with Cash for Clunkers in full force. The headlines said that economists were shocked. Really? Consumers are saving more, and actually paying down credit-card and bank debt. We will go into those details more next week, as it is getting close to time to hit the send button.

Some Thoughts from Maine

Last weekend I got to go to Leen's Lodge at Grand Lake Stream in Maine (www.leenslodge.com - highly recommended) to meet with 35 economics types and their friends. This is a very knowledgeable group, with a lot of well-known names. We fish in the morning, meet at a campsite for lunch (drink wine and eat what we caught), fish some more, go back to the lodge, eat a gourmet meal and drink some more wine, and then go on talking. This goes on for 2-3 days. I throw my diet to the wind, and pay for it over the next month, but it's worth it.

On Friday Steve Liesman and some local guides bring out their guitars and entertain, with a lot of loud, if somewhat off-key, singing from the crowd. (Liesman, by the way, really can play the guitar quite well.) On Saturday night we bet on the future of the markets and events - typically small amounts, and lots of side bets. This year I won five out of six side bets I made last year.

As usual, bets were all over the board. But a few interesting ones surfaced. David Kotok and George Friedman offered rather (for this crowd) large sums to take on all comers that Bernanke would not be reappointed. I took part of that offer, as did a number of others (for the record, the Fed economists at the meeting do not bet and were quite closed on the topic). I was surprised at the intensity of that debate. This is a well-informed crowd when it comes to Fed policy and actions, and if this question is (politely) contentious among friends in July of 2009, what will it be like in the latter part of the year, when Obama has to make the appointment (Bernanke's appointment is up in January of 2010)? And among those who do not get along? This could be a very noisy appointment process.

A few years ago (2006 and 2007), I was repeatedly told I was "too bearish." Now, my Muddle Through prediction was seen either as overly optimistic or the most likely scenario by a large number of attendees. The concerns about the credit markets are still quite strong, with many thinking we will be facing banking problems for years. There were more than a few who bet that Citibank will not be around in its current form by this time next year. (I did not take that bet.)

A number of participants saw a double-dip recession as a distinct possibility. I think it is a probability in 2011 as the Bush tax cuts expire. If Congress moves up the increase in taxes to 2010, which is what the House Democrats want, that recession could start in 2010.

Tulsa, Birthdays, Weddings, and Paul McCartney

Today is my mother's 92^nd birthday, so I need to leave soon, as she eats early. The order of the day is Luby's Cafeteria. Interestingly, she had me when she was 32, and Tiffani is 32 and will have her first around Christmas. Other than her hearing, mother is still going strong, if a little more slowly, and shows no real signs of letting up. She is now bionic, with two new knees and hips over the last decade.

Next week I leave for Tulsa on Thursday to prepare to give away my daughter Amanda on Saturday to a nice young gentleman, Allen Porter. They (along with her twin sister Abigail) say they intend to move to Dallas after the first of the year, which will make Dad happy, as all the kids will be in the local area. A little golf on Friday morning with the new in-laws, parties, and so on. It should be a large wedding and a fun weekend. They have lots of friends, it seems. I do intend to write my letter as usual.

I also intend to be in the bar on Thursday night at the Hilton at 9:30-45, assuming Southwest is on time. If anyone cares to meet, feel free to drop by.

Thinking about Mother's birthday reminds me that I turn 60 on October 4. For whatever reason, it is not bothering me like 50 did. Maybe 60 is the new 45? Paul McCartney is now 66, and is on the road with what I am told is a very good show. I will find out Wednesday when he plays Dallas and I get to go to the new Cowboy Stadium to see him play. With most of his set scheduled to be Beatles tunes, I am really looking forward to being there. I got to see Eric Clapton last month. He is on top of his game. Maybe blowing through 60 is not all that bad.

Have a great week. I shall.

Your hoping I can avoid paying for another wedding for a few years analyst,

John Mauldin

The Great Reflation Experiment

John Mauldin — Fri, 31 Jul 2009 15:04:00 GMT

The Great Reflation Experiment
The Debt Super Cycle
Some Background on US Inflation
Implications for Investors
A Beach, New York, and Maine

The question we have been focused on for some time now is whether we end up with inflation, or deflation, and what that endgame looks like. It is one of the most important questions an investor must ask today, and getting the answer right is critical. This week, we have a guest writer who takes on the topic of the great experiment the Fed is now waging, which he calls The Great Reflation Experiment.

One of my favorite sources of information for decades has been and remains the Bank Credit Analyst. It has a long and storied reputation. One of their enduring themes has been the debt super cycle. Investors who have paid attention to it have been served well. I am taking a little R&R this weekend, but I have arranged for my friend Tony Boeckh to stand in for me. Tony was chairman, chief executive, and editor-in-chief of Montreal-based BCA Research, publisher of the highly regarded Bank Credit Analyst up until he retired in 2002. He still likes to write from time to time, and we are lucky enough to have him give us his views on where we are in the economic cycles. Gentle reader, we are all graced to learn from one of the great economists and analysts of our times. Pay attention. Central bankers do. You can read his extensive bio at www.boeckhinvestmentletter.com and I will tell you how to get his letter free of charge at the end of this letter. And, he told me to mention that his son Rob is now helping him write, so there is a double byline here. Now, let's just jump in.

By Tony Boeckh and Rob Boeckh

The Crash of 2008/9 should be seen as yet another consequence of long-term, persistent US inflationary policies. Inflation doesn't stand still. It tends to establish a self-reinforcing cycle that accelerates until the excesses in money and credit become so extreme that a correction is triggered. The bigger the inflation, the bigger the correction. Once a dependency on credit expansion is well established, correcting the underlying imbalances becomes extremely difficult. Reflation has occurred after each major correction, and this one is proving no exception. Return to discipline in the current environment would be too painful and dangerous. Once on the financial roller coaster, it is very hard to get off. Moreover, the oscillations between peaks and valleys become increasingly large and unstable.

Policymakers, money managers, and most forecasters have argued that the crash was a "black swan" event, meaning that it had an extremely low probability of occurrence. That is grossly misleading, as it implies that the crash was so far beyond the realm of normal probabilities that it was unreasonable to expect anyone to have foreseen it. That argument has been used to justify the widespread complacency that prevailed in the years leading up to the crash. Policymakers are still failing to recognize the systemic causes of the crash and seem to believe that enhanced regulation will prevent history from repeating. While it is true that regulators were asleep at the switch or looking the other way, they were not the cause.

The Debt Super Cycle

The real culprit is the US debt super cycle, which has operated for decades, mostly in a remarkably benign manner. The inflationary implications of the twin deficits (current account and fiscal), as well as the steady increase in private debt, have been moderated by the integration of emerging markets into the global economy. The massive increase in industrial output from China, India, and others has enabled persistent credit inflation in the US to occur with virtually no consequence to date (other than periodic asset price bubbles and shakeouts). How long the disinflationary impact of emerging-market productivity growth will persist and how long these nations will continue loading up on Treasuries, will be instrumental in determining the course that the Great Reflation will take.

Tougher regulation is surely appropriate, but it will not stop the next inflationary run-up unless the system is fixed. In the final analysis, newly minted money and credit must find a home somewhere.

Some Background on US Inflation

Inflation, to be properly understood, should be defined as a persistent expansion of money and credit that substantially exceeds the growth requirements of the economy. As a consequence of excessive monetary expansion, prices rise. Which prices go up and at what rate depends on a number of factors. Sometimes it is the prices of goods and services that are the most visible symptom of inflationary pressures. That was the case in the 1970s when the Consumer Price Index (CPI) hit a peak rate of 14% per annum. Sometimes it is the prices of assets such as homes, office buildings, stocks, or bonds that reflect the inflationary pressure, as we have seen in more recent years.

When inflation becomes pervasive, and other conditions are supportive, it can engulf a whole industry. We saw this in the financial sector in the period leading up to the crash. The supporting conditions or "displacements," to use the terminology of Professor Kindleberger, were financial innovation, deregulation, and obscene profits and salaries. These drew millions of bees to the honey. All great manias are accompanied by malfeasance, in this case the biggest Ponzi scheme in history and many other lesser ones. It is relatively easy to steal when prices are rising and greed is pervasive. Overspending and a general lack of prudence always become widespread when a mania infects the general public. Rational people can do incredibly stupid things collectively when there is mass hysteria.

The origins of post-war inflation go back to the late 1950s and early 1960s, though some would take it back much further. In the 1960s, the US dollar started to come under pressure as a result of US inflationary policy and foreign central banks' ebbing confidence in their large and growing dollar reserve holdings. The US responded with controls and government intervention in a number of areas: gold convertibility, the US Treasury bond market, the Interest Equalization Tax, and, ultimately, intervention on wages and prices. These moves clearly flagged to the world that external discipline would be subjugated to domestic employment and growth concerns. The policy was formalized when the US terminated the link between gold and the dollar in August 1971, essentially floating the dollar and setting the US on a course of sustained inflation. Of course, the dollar floated down, which, among other things, triggered the massive rise in general prices in the 1970s.

The next episode of credit inflation began in the 1980s, paradoxically triggered by the success of Paul Volcker's move to break the spiral of rising general price inflation through very tight money. He succeeded famously, and the CPI headed sharply lower along with interest rates, setting the stage for the massive US debt binge and the series of asset bubbles that followed. It was easy for the Federal Reserve to pursue expansionary credit policies while inflation and interest rates were falling.

The Great Reflation Experiment of 2009

Private sector credit, the flipside of debt, maintained a stable trend relative to GDP from 1964 to 1982 (Charts 1& 2). After that, the ratio of debt to GDP rose rapidly for the 25 years leading up to the crash, and is continuing to rise. The current reading has debt close to 180% of GDP, about double the level of the early 1980s. The magnitude and length of this rise is probably unprecedented in the history of the world. Even the credit inflation that was the prelude to the 1929 crash and the Great Depression only lasted five or six years.

Prior to government bailouts and stimulus, the panic, crash, and precipitous economic decline of 2008/9 were clearly on track to be much worse than the post-1929 experience. The pervasiveness of leverage - from banks to consumers to supposedly blue-chip companies - and the illusion of stability in the system, were fostered through the 25 years that this credit bubble has grown, basically uninterrupted. The speed and magnitude of the bailouts and stimulus - the end of which we won't see for a long time - aborted the meltdown. However, the story is far from over.

The Great Reflation Experiment ultimately has two components. The first is a rise in federal government deficits, debt, and contingent liabilities. The second is an expansion of the Federal Reserve's balance sheet. Both are unprecedented since World War II. US federal government debt is likely to reach close to 100% of GDP over the next 8 to10 years, according to the Congressional Budget Office (CBO) and supported by our own calculations (Chart 3). Anemic growth, falling tax revenue, increased government spending, and bailouts of indigent states, households, businesses, along with an aging population, will all undermine public finances to a degree never before seen in peacetime. According to CBO data, government debt could reach 300% of GDP by 2050 as contingent liabilities are converted into actual government expenditures. This massive peacetime deterioration in public finances will have grave consequences for living standards and asset markets, particularly in the longer run.

In the short run, huge deficits and growth in government debt are necessary. They will continue to play a crucial role in deleveraging the private sector and in helping to fill the black hole in the economy that has been caused by the sharp increase in household savings. Further out, government deficits will put upward pressure on interest rates. However, much of the economy, particularly housing and commercial real estate, is far too weak to absorb an interest-rate shock. Therefore, the Federal Reserve will have to monetize much of the rise in government debt, making it extremely difficult to unwind the explosion in the Fed's balance sheet and consequent rise in bank reserves - the fuel that could be used to ignite another money and credit explosion.

The bottom line is that the Fed is in a very difficult position. Its room to maneuver is either small or nonexistent, and the markets understand this. That is why there is a sharp divergence between those worried about price inflation and those fearing a lengthy depression.

Implications for Investors

Investors are also in an extraordinarily difficult predicament. From the peak in 2007, household wealth declined by about $14 trillion, over 20%, to the first quarter of 2009. Tens of millions of people had come to rely on rising house and stock prices to give them a standard of living that could not be attained from regular income alone (Chart 4). They stopped saving and borrowed aggressively and imprudently against their assets and future income, some to live better, some to speculate, and many to do both. That game is over.

Pensions have been devastated and people's appetite for risk has declined dramatically. The return on safe liquid assets ranges from 0.60% to 1.20%, depending on term and withdrawal penalties. Reasonable-quality bonds with a five-year maturity provide about 4%. Bonds with longer maturities have higher yields but are vulnerable to price erosion if inflationary expectations heat up. As for equities, people now understand that blue chip stocks carry huge risk. GE, once considered the ultimate "bullet-proof" stock, dropped 83% in the panic, and Citigroup lost 98%. Revelations of massive fraud schemes have further damaged trust and confidence in markets.

Against this backdrop we offer a few thoughts. First, an increase in price inflation as reflected in the CPI is a long way off. The degree of excess capacity in the world is probably the greatest since the 1930s, although excess capacity does get scrapped during recessions. Western economies will remain depressed for years, and China will also be important in keeping inflation down. Its capital investment is larger than the US's in absolute terms. It is currently 40% of GDP and growing at 30% per annum. Profit margins in China will probably get squeezed, which, together with the huge amount of underemployed labor, means that the Chinese will keep driving their export machine at full throttle, continuing to flood the world with high-quality, inexpensive goods. Therefore, investors who need income are probably safe holding reasonably high-quality bonds in the five-year maturity range. A bond ladder is a very useful tool for most people. Holdings are staggered over, say, a five-year time frame, and maturing bonds are invested back into five-year bonds, keeping the portfolio structure in the zero-to-five-year range. In this way, some protection against a future rise in price inflation and falling bond prices can be achieved.

Second, massive monetary stimulus is good for asset prices in the near term (e.g. stocks, bonds, houses, commodities) in a world of very weak price inflation and a soft economy. That is true as long as the economy does not fall apart again, which is very unlikely given all the stimulus present and more to come if needed. Therefore, investors who can afford a little risk should own some assets that will ultimately be beneficiaries of the wall of new money being created and thrown at the economy.

There is a major risk to our relative near-term optimism, and that is the US dollar. Foreign central banks hold $2.64 trillion, overwhelmingly the largest component of world reserves. The US role as the main reserve currency country is compromised by its persistent inflationary policies and current account deficits, a subject high on the agenda at the recent G-8 meeting in Italy and referred to frequently by China, Russia, Brazil, and others. Foreign central banks fear a large drop in the dollar, which would cause them potentially huge losses on their reserve holdings. They don't want more dollars, and yet they don't want to lose competitive advantage by seeing their currencies go up against the dollar. To preserve their competitive position, they have to buy more when the dollar is under pressure. On the other hand, since the 1930s the US has never subjugated domestic concerns to external discipline. Officials may talk of a strong-dollar policy, but their actions always speak differently. Their attitude towards foreign central banks is, "We didn't ask you to buy the dollars." The US has typically seen such buying as currency manipulation to gain an unfair trade advantage.

The most likely outcome is a nervous dollar stalemate or, as Lawrence Summers once described it, "a balance of financial terror." The most important central banks will continue to hold their noses and buy the dollar to keep it from falling too sharply. However, this is a fragile, unstable situation, and the dollar must fall over time. Investors need to diversify away from this risk. There are three obvious ways.

The first is investing in high-quality US equities that have a majority of their earnings and assets in hard-currency countries.

The second is investing in gold and related assets. Gold will probably remain in a tug of war for some time. On the negative side, it is faced with nonexistent global price inflation, even deflation, and a sharp decline in jewelry demand. On the positive side, concerns over U. monetary and fiscal debauchery will almost certainly heat up. As the odds of the latter increase, gold will be a major beneficiary, and investors should have a healthy insurance position in this asset class.

Third, most foreign currencies will also benefit from these fears, and hence investors can also protect themselves by diversifying into non-dollar assets in the best-managed countries. Some of these are emerging markets like China, which are liquid, in surplus, fiscally stable, and still growing well in spite of the global economic downturn. If and when the world economy begins to recover, and should price inflation stay low, asset bubbles are likely to recur. Where and when is always hard to tell in advance. Good prospects are in emerging-market equities, commodities, and commodity-oriented countries.

So, to sum up, in the next six to 12 months we look for a weak but recovering US economy, a continued deflationary price environment, pretty good asset and commodity markets, and continued narrowing of credit spreads. This view is based on the assumption that the new money created has to go somewhere, a stable to modestly falling dollar, and an anemic world economic recovery next year.

A buy and hold strategy has been bad advice for the past 10 years. The S&P is down 45% from its peak in early 2000. The investment world is likely to remain very unstable in the face of the difficult longer-run problems discussed above. Investors, whether they like it or not, are in the forecasting game, and forecasting is all about time lags. The exceptional circumstances of the current environment make any assessment of time lags extraordinarily difficult, and mistakes will continue to be costly. For that reason, holding well above average liquidity, in spite of the paltry returns, is sensible for most people whose pockets are not deep enough to absorb another hit to their net worth. They are in the unfortunate position of having to wait until the air clears a bit and more aggressive action can be taken with higher confidence. Warren Buffet has properly reminded us on numerous occasions that a price has to be paid for waiting for such a time, but then most of us aren't as rich as he is.

A Beach, New York, and Maine

I want to thank Tony and Rob for writing this week's letter. You can go to their website, www.boeckhinvestmentletter.com and see some of their recent letters, or send an email to info@bccl.ca and get put on their regular list for the free letter.

As you are reading this, I am hopefully reading on a beach, relaxing under an umbrella. Tiffani and Ryan are on a cruise in the Caribbean. They just got back the wedding videos from last year, and they are a hoot. They had one cameraman with an old Super 8 camera, so that video looks like something from the 60s. At some point they will put it on You Tube. Interesting to contrast the old format with the new.

I get back late Monday, and then leave early Wednesday for a quick trip to New York and then on to the Shadow Fed fishing weekend organized by David Kotok. My youngest son, now 15, will be with me for our fourth trip. Maybe this year I can catch more than he does. So far, it has not even been close in either quantity or quality.

Each year, we make small bets (bragging rights are more on the line) on where the markets will be the next year. So far, I am money ahead, as I get a few calls right. Last year the financial markets were just starting to melt down as we met. It will be interesting to see if any of us came close this year. There are some fairly well-known names in the room, so it will be interesting to see who got it right. And even more interesting to try and figure out where we will be next year at this time. I will report back.

And that blank spot that was my fall travel calendar? Looks like I will be going to South America in the fall (Argentina, Brazil, and Uruguay). A few other dates look to be firming up. It has been way too long since I was in South America, and I am looking forward to it.

Have a great week.

Your going to mix in some sci-fi with the economics reading analyst,

John Mauldin

The Statistical Recovery

John Mauldin — Sat, 25 Jul 2009 05:24:00 GMT

The Return of Muddle Through*
Can China Lead the Global Recovery?
The Statistical Recovery
The Last Bear Standing
New York, Maine and Tulsa

A lot of bullish commentators are talking about a recovery being in the works, and they may very well be right. But it is not going to look like any recovery worthy of the name. This week we look at what I will call The Statistical Recovery. But first we take a look at what China is doing, as we continue our look at the rest of the world and ponder whether it is time to brace ourselves for an extended bout with the Muddle Through Economy*. (And yes, there is an asterisk.)

Quickly, and importantly, tonight we are releasing the first in a new series of quarterly Conversations entitled Geopolitical Conversations with John Mauldin and George Friedman. We believe that these new Conversations will help you better understand not only the global political landscape but also how it affects the financial umbrella that we are under. In this first Conversation, we talk about the "exogenous" risks to the markets (those from outside the markets themselves) posed by the geopolitical world.

George and I are going to make it a regular quarterly gig. We will offer this service, which will be priced separately, at some point in the near future. Now, here is the important part: all current subscribers and anyone who subscribes now will receive these Geopolitical Conversations free, as a thank you. (Current members can log in now.) If you have not yet subscribed, you can do so and receive a discount, by clicking the link and typing in the code JM47 to subscribe for $149. This is a large discount from our regular price of $199; plus, we are including the bonus Geopolitical Conversations that are worth $59.

Further, we will post a separate interview next week that I have obtained permission to use from my friends at Casey Research, and which I personally found very valuable. When we launched Conversations, we promised eight interviews a year. We are now at six, and next week I will record the seventh with housing experts John Burns of John Burns Real Estate Consulting and Rick Sharga of Realty Trac, the two leading experts on housing in the country. There is SO much uninformed, simplistic misinformation in the media about housing that I thought subscribers might like to know what the real situation is.

When you subscribe, all of the past Conversations are there for you to review. I am going to make sure subscribers get way more than their money's worth. You don't want to wait another day to subscribe. And now, let's jump into this week's letter.

Can China Lead the Global Recovery?

China is growing by about 8% a year, which is amazing on the surface of it, as their exports are down about 20% (more in some sectors). How can that be? I continually read about how China is going to lead the world out of its global funk. And 8% growth in GDP does seem pretty strong. But we need to look a little deeper.

If I told you that the next US stimulus package would be $4.5 trillion dollars, mostly given to banks that would be forced to loan out the money quickly, do you think that might jump spending and GDP in the short term? Would you start looking for a few bubbles to be created? What about the dollar?

That is the equivalent of what China is now doing. The volume of credit that is flowing into China is equivalent to one-third of their GDP. Banks that already have large problem-loan portfolios are now lending even more, in a very short time frame. China has severe capacity-utilization problems, as trade has sharply fallen; and the US consumer is unlikely to return to anywhere near the level of consumption that was the case in 2006.

The Chinese stock market is up 85% this year, and commodity and real estate prices are rising. And no wonder: the money supply shot up 28.5% in June alone. That money is looking for a home. My friend Vitaliy Katsenelson has written a very perceptive essay for Foreign Policy magazine, talking about the nature of the current growth in China.

"But don't confuse fast growth with sustainable growth. Much of China's growth over the past decade has come from lending to the United States. The country suffers from real overcapacity. And now growth comes from borrowing -- and hundreds of billion-dollar decisions made on the fly don't inspire a lot of confidence. For example, a nearly completed, 13-story building in Shanghai collapsed in June due to the poor quality of its construction.

"This growth will result in a huge pile of bad debt -- as forced lending is bad lending. The list of negative consequences is very long, but the bottom line is simple: There is no miracle in the Chinese miracle growth, and China will pay a price. The only question is when and how much."

I am going to quote at some length from Simon Hunt's latest note. He travels very frequently to China and is one of the world's true experts on the copper market. If you want to know something about copper, ask Simon. Copper, we are told, is the metal with a PhD in economics. If copper prices are rising, then the economy is booming. And historically, that has more or less been the case. But there may be reason to believe that PhD may be no more useful this time around than a regular Ivy League degree.

"The world community has come to see that China is its savior. Growth picked up sharply in the second quarter, but it is based on fixed asset investment and renewed speculative activity in the real estate sector. It is not what the actual GDP or IP [Industrial Production] numbers will show that matters, but the quality of that growth. Money is cheap with loans and credit freely available, so much so that China risks developing new bubbles in the stock and commodity markets and real estate. Speculation is based on the simple premise that prices must rise. Foreigners as well as domestic participants are feeding this frenzy, especially in metal markets.

"The frenzied loan and credit growth is unlikely to be cut back until the fourth quarter at the earliest. It is not this year or next which worries us, but post 2010. What will China do when the world economy gets hit with its next big leg down?

"There is no better example of this speculative activity than what is being seen in the copper market. It is easy for global merchants, hedge funds etc to ship cathode into China and warehouse it outside the reporting system, so fuelling investors' sentiments that copper demand in China is soaring and at the same time draining copper from the rest of the market.

"It is not so much industry which is doing this buying in China, but individuals, financial institutions and even small companies divorced from the copper industry who are buying and holding the metal because copper is a store of value and prices will go up is the common response. We updated our numbers for the first half of this year. They are truly staggering. Over 1 million tonnes of cathode is sitting in China mostly outside the reporting system as a punt on rising prices." (Emphasis mine)

If it is happening in copper it is likely to be happening in other commodity markets as well. If you are trading the metals, you should be aware that a quick drop could happen if demand falls off due to there being a glut of supply coming back onto the market.

Why would China engage in what seems from our shores to be very risky behavior? Because from their point of view it makes sense. It is not a lot different in concept than what the US or England is doing to stimulate their economies. The scope and size are different, but China also has a much different problem. They are attempting to soften the transition from an economy dependent on the US consumer to one that is more balanced. Will they be successful? The answer depends on what they are actually trying to do. You could (and should) also ask whether Bernanke will be successful when he decides to remove reserves from the economy. Avoiding financial Armageddon may be the measure of success in both countries, with the reality that there will be some pain, no matter what.

Who Ends Up with the Old Maid?

But the important news out of China this week was the assertion that China was getting ready to use its massive $2.2 trillion reserves. From the Financial Times:

class=MsoBodyTextIndent>"Beijing will use its foreign exchange reserves, the largest in the world, to support and accelerate overseas expansion and acquisitions by Chinese companies, Wen Jiabao, the country's premier, said in comments published on Tuesday. 'We should hasten the implementation of our "going out" strategy and combine the utilization of foreign exchange reserves with the "going out" of our enterprises,' he told Chinese diplomats late on Monday. Mr. Wen said Beijing also wanted Chinese companies to increase its share of global exports. The 'going out' strategy is a slogan for encouraging investment and acquisitions abroad, particularly by big state-owned industrial groups such as PetroChina, Chinalco, China Telecom and Bank of China."

This is a very big deal, and from the Chinese point of view, quite smart. Right now they are stuck with $2 trillion in US Treasuries, agency paper, etc. They can't sell their dollars without really hurting the dollar, thereby forcing the renminbi to rise and hurting their own exports. But they, and much of the world, feel that the US is pursuing policies that are going to be harmful to the value of the dollar and therefore to China's largest reserve exposure.

What to do? Take those dollars and buy physical assets. Companies, natural resources, maybe a few small countries. (To my Chinese readers: that's a joke, although some in the West worry about that.)

In the card game called Old Maid we played as kids, the loser was the one who ended up with the "Old Maid" at the end of the game. For the past decade, the Chinese sent us "stuff" and we sent them dollars in the form of electrons. They in turn invested those dollars in our debt so we could buy more stuff. It was a form of vendor financing.

And now the Chinese have apparently decided to pass the Old Maid of the dollar on to other parties, who will sell them their assets for dollars. Seriously, did anyone not think they would do this? Massively selling the dollar, which so many conspiracy-theory types keep saying they will, was never really a rational option. But using those dollars to acquire productive assets? Very smart, very rational. If you figure out what they want to buy and get there first, there are profits to be had. Attention should be paid.

$2.2 trillion in reserves and growing can cover a lot of economic sins and bad bank loans. It can buy time for the companies with too much production capacity in China to find new customers. Will it be a smooth ride? Of course not. There will be a lot of bankrupt companies and a lot of angst among the entrepreneurial class. That is part of the process. But in five or ten years, China will be larger and stronger than it is today. Count on it.

That being said, is it likely China will pull the world out of its current slump? Not for a while. China is just 7% of global GDP. Even if they grow at 8%, that only adds 0.5% to global growth, and it is likely that we will see global GDP shrink by 2.7% in 2009. Look at the chart below from my friends at Hayman Advisors.

A few side observations on the above graph. China is roughly as big as the other three of the BRICs (Brazil, Russia, and India) combined. Russia and Brazil are in recessions. Also, note that it will be decades before China's economy is as big as that of the US, even with growth of 5-6% a year more than that of the US. Will it eventually be as big? Of course, and it should be; tt has four times more people.

Will it matter? Not a bit. Does Denmark care that the US or Germany is bigger? Not that I can tell. Does Dallas care if New York is bigger? You just deal with the reality in front of you and try and make the most of what you have. If you focus on the other person or country, you lose sight of your own goals.

Further, I rather doubt that China will be growing by 8% a year in 15 or 20 years. Like all large economies, they will start to experience slower growth. And they will have their own demographic problems in a few decades as a result of the "one child" policy. Every country has to deal with its own specific issues.

That being said, will there be opportunities in China and other emerging-market countries? You bet. I rather think that the developing world will be where the real opportunities will be as the world figures out what the New Normal will look like.

And now, let's look at a few issues the US will have to deal with.

A Statistical Recovery

"I've been down so long it looks like up to me," went the song of my youth. The recessions is not quite two years old. Every day we are hit with increasing unemployment, lower incomes, rising taxes, and more - a relentless stream of bad news. We wonder whether it will ever end. And the answer is that of course it will. And it may be ending now. But this is going to feel like a very different recovery from what we normally think of as recovery. It will be more of a statistical recovery than a real one.

The easiest way to explain that concept is to look at the following graph. At one point, housing construction was over 5% of GDP. Now it is around 2.5%. The graph shows how much a shrinking home-construction industry has reduced GDP each quarter for the last two years.

Without going into a lot of detail, housing construction may be at a bottom, or at least there is less room to fall. Instead of housing subtracting 1% (or more) from GDP each quarter, it may become a nonfactor as a bottom is reached. Does that mean recovery? No, it just means that things aren't getting worse. We are finding that level of the New Normal.

Ditto for inventories. At some point, you have to restock the shelves. Rail shipments are down by almost 20% from last year, and UPS package volume is down 4.7%. And as Dave Rosenberg pointed out this morning, that is from last year's already depressed levels. As Alan Blinder noted today in the Wall Street Journal, at some point you finally get to bottom. Housing, inventories and business investment stop subtracting from GDP, and the GDP stops shrinking.

And as I pointed out a few weeks ago, the fact that we are buying less from outside of the US (imports) may show economic weakness, but from a statistical point of view that is positive for GDP.

All of this means that we could see – actually, we will see – a positive GDP number at some point. Those of bullish persuasion will talk of recovery. But for the 10%-plus people who will not have a job next year, it is not going to seem like a recovery. Nor for the additional 7% (at least) part-time employees looking for full-time work.

Go back to 2001. We had "the end of the recession." Bulls were out in force, trying to talk up the market. But unemployment still rose for almost a year. And the stock market noticed. The market did not really take off for well over a year, and actually continued to slide into 2002.

The Last Bear Standing

Notice in the chart below that unemployment continued to rise until the first quarter of 2003. And that is also when the stock market took off. Those who see green shoots need to think about that. Meanwhile, the market is clearly telling us that it sees nothing but blue skies in the future. I truly marvel at this rally, but I continue to think it is a bear-market rally. The weakest, high-beta names are rallying the most. This rally does not seem to be the basis for a sustained bull market. That being said, Richard Russell has removed the bear from his letter and put in a bull. I may be the last bear standing.

The media tells us earnings are coming in above expectations. But expectations have been lowered so much that the target is much easier to hit. Even then, the "upside profit surprises" are coming from cost cutting, which is not sustainable as a profit center, at least not if you are trying to grow the business. And laying off employees, while perhaps good for the profits of one company, is not good for the overall economic business environment.

The Muddle Through Economy*

This is going to be a long, jobless recovery. Hours worked per week are at an all-time low. As noted above, part-time work is very high. Employers, when things actually start to turn around, and they will, will first give current employees more hours and then expand the hours of part-time workers. There will be few new jobs for a long time.

Because our population is growing, between 130-150,000 new jobs are required each month to keep unemployment from rising. Initial and continuing claims suggest we are currently losing at least 300,000 a month.

(As an aside, the media talks about initial unemployment claims falling. That is actually not true. Unemployment claims are in fact quite high and rising, but the seasonal adjustments make them look smaller. Normally, this would not be a big deal. But the summer seasonal adjustment assumes a normal automobile manufacturing market, with layoffs in July. The layoffs came much earlier this year, distorting seasonal adjustments.)

Higher and persistent unemployment, lower incomes and wages, higher savings rates, capacity utilization at 50-year lows and still falling, rising home foreclosures, a deleveraging financial system, etc. are not the stuff of "V-shaped" recoveries. Throw in that Moody's estimates that US banks will have to write off $400 billion in 2010, and it's a very weak recovery indeed that shapes up for next year.

It's the return of The Muddle Through Economy*, which is better than what we have had, to be sure. But that asterisk is there for a reason. Congress and the Obama administration are seemingly hell bent on a massive tax increase. If that happens, it will push a fragile recovery back into recession. It will look like the twin recessions of 1980-82.

It will be a difficult investing environment, to say the least. If buy-and-hold is not your favorite style, there are alternatives. Quick commercial: my friends at CMG have a platform of alternative managers that can be tailored to your specific needs. These are traders who have weathered the storms of this last decade. These are individually managed accounts, with daily liquidity. You really owe it to yourself to see the managers on their platform. The link to their form is http://www.cmgfunds.net/public/mauldin_questionnaire.asp.

I am encouraged by the fact that the radical health reforms look like they might not pass. The health-care system clearly needs a major overhaul. Let's hope that we get it right.

In a future letter, I am going to talk about taxes. I am concerned that we are going to raise taxes now to very high levels, and not leave any room for the tax increases we are going to desperately need in the middle of the next decade to pay for entitlement programs. That will mean a VAT tax and tax increases on the middle class. Again, not good for the economy. But enough for today. Time to hit the send button.

New York, Maine, and Tulsa

Next week I am going to take a few days off and head for a beach somewhere, along with my summer reading list. I will get back for one day, and then with my 15-year-old son head for New York for an evening dinner with Art Cashin, Ron Insana, and George and Meredith Friedman. That should make for interesting conversation.

Then off the next morning to Maine, after shooting a few spots with Aaron Task and Henry Blodgett at Yahoo! Tech Ticker. CNBC and Steve Liesman will be at the Shadow Fed fishing event, and it looks like I will do a few minutes with him, as they plan to do an hour-long special with many of the investment writers, economists, and analysts who will be there. I am really looking forward to that trip.

And then back home for a few weeks before going to Tulsa for Amanda's wedding on the 22^nd. Amanda was a competitive cheerleader for a long time, and she is bringing that drive to the wedding. If there is deflation in this country, it is not in wedding costs. Two weddings in two years has me breathing hard. And two more to go, although right now it looks like that might not be soon. And if the job market will help out, Amanda and Allen (her fiancée) and her twin sister Abbi intend to move back to the Dallas area after the first of the year, which will mean I'll have all seven kids close to me again. I really look forward to that.

We tend to get together as a family for brunch at least every other Sunday, and it's a fun day for me. Lots of love and laughing -- and now babies. And more on the way! There is a bull market in my joy in my kids, that's for sure. And now it really is time to hit the send button, as I am off to the local pub to have a drink with #2 daughter Melissa. She is going to have to have her gall bladder removed, and Dad likes to check in now and then. Have a great week, and enjoy your summer before it goes away,

Your doing better than Muddle Through analyst,

John Mauldin

Europe on the Brink

John Mauldin — Sat, 18 Jul 2009 03:30:00 GMT

Europe on the Brink
And Then There Was Leverage
Too Big To Save
Those Wild and Crazy Swiss
A Positive Third Quarter?
New York and Maine

We have avoided Armageddon, at least for now. The cost to the US taxpayer has been a few trillion. Some in the media are loudly announcing the end of the recession. But we are not out of the woods yet. There are a few more bumps in the road. Actually, some of them are quite steep hills. As big as the subprime problem? Maybe.

When asked a few weeks ago what was my biggest short-term concern, I quickly replied, "European banks have the potential to create significant risk for the entire worldwide system." This week we will glance "over the pond" to see what gives me cause for concern. Then we briefly look at a few of the bumps I mentioned, which are likely to stretch out any recovery, and maybe even dip us back into recession.

But first, a quick announcement. We are making dramatic changes to my free Accredited Investor E-Letter and service, and will have a new web site and much improved content in a month or so. But in the meantime, I have just finished a new letter; and if you sign up at the current site, you will of course get all the new services and benefits when we make the changes, as well as this new letter. Basically, this service is for accredited investors (net worth of $1.5 million or more) who are interested in learning more about and investing in alternative funds like hedge funds, commodity funds, and so on. You will get a call from one of my worldwide partners (Altegris Investments in the US, Absolute Return Partners in Europe, Nicola Asset Management in Canada, Plexus Asset Management in Africa, and Fynn Capital in Latin America) and gain access to a lot of information and an easy way to preview what I think is a great line-up of quality funds and managers. You can go to www.accreditedinvestor.ws and sign up today. Don't procrastinate! (In this regard, I am president and a registered representative of Millennium Wave Securities, LLC, member NASD.)

And for those of you in the US who are on your way to becoming accredited investors (but not there yet), my friends at CMG have a platform of alternative managers that can be tailored to your specific needs. You really owe it to yourself to see the managers on their platform. The link to their form is http://www.cmgfunds.net/public/mauldin_questionnaire.asp. And now, let's jump into the letter.

Europe on the Brink

Globalization is a two-edged sword. On balance, it has brought prosperity to those who have embraced it, with rising lifestyles, better health, longer lives, and more. The more we need each other, the less likely it is that we'll shoot each other. Shooting your customers is not a good business strategy. And while the growth has not been even or smooth, only a Luddite would want to return to the early 1800s or 1900s, or even 1975.

The other edge of that sword? We are connected in so very many ways, far more than most of the world suspected. Who thought that insane lending policies at US mortgage banks would bring the world financial system to its knees, increasing unemployment and leading to a global recession? World trade is down 20% or more. US railroad shipments are down more than 20% year-over-year. Chinese (and Asian) factories have seen their orders drop, as US consumers have gone on strike. The US trade deficit was just $25 billion last month; and while our exports are still dropping, our imports are dropping more. Oil is becoming a bigger and bigger share of imports, and that does not come from Asian exporters.

The US is far and away the country with the largest gross domestic product (GDP). California would be the 7^th largest country, but few think of California in such terms. For this letter, at least, I would like to think of Europe as a whole rather than as 27 countries. From that perspective, Europe is as economically important to the world as the US. What happens in Europe makes a difference in the US.

Last week we looked at the precarious position of Japan, the second largest economy (or third if you think of Europe as a whole). It was a sobering letter. When you realize the extent to which Japan has funded Asian expansion, what is happening there cannot be good for the world.

But Europe's banks have been much more aggressive in funding emerging-market expansion than US or Japanese banks. Western European banks have lent $4.5 trillion to various emerging-market countries, businesses, and consumers. Many Eastern European businesses borrowed in low-interest-rate euros. New homeowners in Hungary and the rest of Eastern Europe borrowed in Swiss francs and euros, and as their currencies have collapsed they now find they owe more on their homes than they're worth.

And here's the problem. Europe's banking system is in far worse shape than the US system. The losses may be bigger, and their capital to meet those losses is certainly less. Let's look at some charts. Remove sharp objects or pour another adult beverage.

As I noted last week, one of the real benefits of writing this letter is that I get to see a lot of really interesting information from readers and meet with very savvy investment professionals. I recently had the privilege of sitting with a team of analysts from Hayman Capital here in Dallas. Hayman runs a global macro hedge fund, so they spend a lot of time thinking about how all the different aspects of the global markets fit together. This week we again look at some of their analysis. There was a lot of work (as in months) done here; and Kyle Bass, the founder of the firm, graciously allowed me to share some of it with you (and kudos to Wes Swank, who pulled this together). The graphs are theirs, and my discussion about them is certainly informed by our meeting; but I am using the material as a launching point, so they are not responsible for my conclusions and interpretations.

And Then There Was Leverage

In the first few years of the G.W. Bush administration, the banking authorities decided it would be OK to allow five banks to increase their leverage from 12:1 up to 30:1. Which five banks, you ask? Bear Stearns, Lehman, Merrill Lynch, JPMorgan, and Goldman Sachs. How did that work out, just five years later? Three are gone and two survived with large dollops of taxpayer money.

(Sidebar: Is it really any surprise that Goldman and JPMorgan are making record profits on the underwriting and trading side of the business? Hell, if I could eliminate 50% of my competition, my profits would grow too! JPMorgan's consumer credit, credit card, and other business groups are losing money big-time.)

Thirty times leverage means that if you lose 3.3%, you wipe out all your capital. And we watched as banks too big to fail were bailed out with taxpayer dollars. Slowly, banks are buying time, writing down assets. Remember, this month is the second anniversary of the onset of the credit crisis. I wrote back then that the strategy would be to stretch this out as long as possible. Time heals a lot of bad debts, especially at a 0% Fed Funds rate.

Banks that are reporting so far this quarter seem to be saying that the write-offs will start to level off in about two quarters, although banking expert Chris Whalen says that the level may stay higher than we think for longer than we think. There are a lot of assets to write off, and they are just now getting to the commercial real estate problems. This is going to take time. (For an interesting interview on CNBC with Maine fishing buddy Chris Whalen, click here: http://www.ritholtz.com/blog/2009/07/christopher-whalen-banking/.)

The point, before we get to Europe, is that here there was a central bank and a government that not only could step in but was willing to. I know former Treasury Secretary Paulson had his critics, but I am not one of them. Did he do some things that in hindsight he might like to take a "mulligan" on? Sure. But he dealt with the problems in the best manner he could. The time to have taken action was when we were making liar and no-doc loans and calling then AAA, or allowing banks to go to 30:1 leverage. Paulson had to deal with eggs that were already broken. That the system did not crater is to his credit. Securitizing what he and everyone else should have known would be garbage while he was head of Goldman Sachs is not to his credit. But I digress.

I am going to give you four charts showing the leverage of banks in the US, the United Kingdom, the Eurozone, and Switzerland. The bottom, blue portion is assets to common and preferred stock; the red is assets to common equity, which can include good will; and the purple is assets to tangible common equity.

Tangible common equity is all the rage, and that is what the recent "stress tests" measured, as opposed to tier 1 capital, which includes preferred stock (which would basically be the blue portion.) TCE only includes common shares. Now, let's start with the US. These graphs show leverage. The average leverage of tier 1 capital of the five largest banks is in the range of 12:1, and is actually down from ten years ago. (By the way, a very good and simple explanation of all this can be found at http://baselinescenario.com/2009/02/24/tangible-common-equity-for-beginners/.)

While the TCE has obviously been rising and taking total leverage to rather lofty levels in the mid-40s, banks are raising capital, and over time leverage will come back down. It helps if you can borrow money at almost nothing and lend it out at much higher rates. Now, let's turn to the United Kingdom. This is uglier.

Regulators in the UK allowed 20:1 leverage on a regular basis. It is now almost 40: and with TCE is around 55. The assets of UK banks are about five times as large as UK GDP. By comparison, for the US the ratio is barely 2:1.

Think about that for a second. The UK has banking assets which are five times as large as the annual domestic output of the country. They also had a housing bubble. They have their own bailouts to deal with, which are massive and will potentially get much larger. But at least they have a central bank and government that can try to fix the problems.

But as the commercial says, "But wait, there's more!" Let's look at the Eurozone.

Leverage is now 35:1 and with TCE is almost 55. How did 35:1 work out for the US? Given the massive credit problems that Eurozone banks have with emerging markets (plus Spain's housing bubble, which is every bit as bad as that of the US), will this not end up in wailing and weeping?

Too Big To Save

And here's the real issue. They have no Paulson and Bernanke. Now some of my Austrian-economist friends will say, "Good, they should all be allowed to die;" but that is a very cavalier attitude when you start talking about actually increasing the unemployment rate to something like 20%. I agree that management should be changed (as well as the regulators: 35:1 to 1 - really? What were they thinking?) and shareholders wiped out, but I do not want the system to collapse. And this is a global risk, not just localized to Ireland or Spain or Austria. Sure, the pain might be worse in the local region, but we will all feel it.

The European Central Bank, at least as of now, cannot step in and start saving individual banks. How do you save a Spanish bank and not an Austrian bank? Austria's banks have made large loans to Eastern Europe, in euros and Swiss francs, and are going to have large losses, far more than 3%, which would wipe out their capital. But bank assets in Austria are 4 times GDP. What we have are banks that are too big to save for relatively small Austria. And for Italy, Spain, Greece, et al. More on this below. For now, let's turn our eyes to Switzerland.

Those Wild and Crazy Swiss

We think of Switzerland as a stodgy, by-the-numbers, clockwork type of banking country. I have done business with Swiss private bankers, and they are conservative. But somewhere, somehow, UBS and Credit Suisse ran up a little leverage. Before the crisis, they were over 40:1. And now they're nearly at a nosebleed-high 70!

As an aside, I was in Switzerland about two years ago, meeting with some very well-known Swiss, let's call them dignitaries. In a very off-the-record conversation, they told me UBS was technically bankrupt. As it turns out, there were a lot of banks around the world that were technically bankrupt.

Now, the next graph underscores the problem of "too big to save." Let's say the US will eventually pump $1 trillion into the banking system (in taxpayer losses). That is about 7% of US GDP. We may not like it, but it doesn't stop the game. US bank assets are only twice US GDP. Switzerland and Ireland are over 7 times, the UK is over 5, and the Eurozone is at 4 times. And so it goes.

Eurozone banks are already reeling from losses from US subprime-related problems. They are now getting ready to deal with even deeper losses from their own lending portfolios. If the losses were just 5% of the portfolio (an optimistic assumption), it would be 20% of Eurozone GDP. But each country is responsible for its own banks. While it is thought Germany will be able to handle its problems, the prognostication for Austria and Italy is not so sanguine. Italy is already running a massive deficit, and has no central bank to monetize its debt. The same goes for Portugal, Spain, Greece, and Ireland. 5% loan losses in Ireland would be 40% of GDP, the equivalent for my fellow US citizens of about $5 trillion. Where does Europe find a few trillion dollars?

I was writing in late 2006 that the subprime lending market would end in tears. And I think the European banking crisis that is on the horizon has the potential to be every bit as big a problem as subprime loans. The world depended on Europeans banks for much of the lending that allowed for growth and development. Like their counterparts in the US, they are going to have to reduce their loan portfolios. Deleveraging is not fun.

It takes time to build up a banking infrastructure that can raise the capital necessary to make and process loans. A lot of time. Europe is a big customer of the US and Asia. Their businesses are going to be hit hard by the lack of capital, which is of course no good for employment, etc. We are all connected. What happens in Rome no longer stays in Rome.

Let me reprint a graph from last week. Burn it into your mind. The world is going to need to find $5 trillion to finance government debt issuance. And we need to fund private business and consumer debt. Where is all this money going to come from? "If you lend me $5 trillion today, I will gladly repay you Tuesday."

A Positive Third Quarter?

Those who are calling for the end of the recession are shouting that the third quarter may be positive in terms of GDP. And that is possible. But only for statistical and not for fundamental reasons. For instance, lower imports are a net positive for GDP. But lower imports mean a weaker economy. Government spending adds to GDP. Normally, if the government spends too much, then we get inflation, which is subtracted from nominal GDP to give us real (after-inflation) GDP. But inflation is low and getting lower, so there is not going to be much to subtract from nominal GDP. Are government spending and massive deficits a sign of fundamental strength?

It is quite usual for there to be a positive quarter in the middle of a recession. Watch the fundamentals: industrial production, unemployment, capacity utilization, tax receipts, etc. When those turn up, or at least level off, the recession is over. Then we get to the long recovery.

Quick point. As I have noted, unemployment is at 9.5% and going to 11% and hopefully no higher. Average hours worked per week is at an all-time low. The number of people working part-time but wanting full-time work is another 7%! And that part-time number is rising very rapidly.

When the recovery actually does begin to manifest itself, and it eventually will as we find the New Normal, what do you think employers are going to do? Hire new workers? Or give their current employees more hours? The latter, of course. This is going to be a long, slow, painful, jobless recovery. Unemployment is going to remain stubbornly high.

And this Congress wants to raise taxes on small business. 75% of the "rich" are small businesses. How do you expand your business in California or New York, where taxes will be over 60% by the time you add in local taxes? We will talk about this next week; but as a preview, from an economic viewpoint, massively raising taxes in the middle of a recession is about as dumb as you can get. But it looks like we are headed there. Green shoots, my foot.

New York and Maine

I'll head to Maine in early August with youngest son Trey to fish with my friends and talk economics. Meanwhile, # 2 daughter Melissa will soon have to have her gall bladder removed. Amanda gets married next month. Two more grandchildren (in addition to the one I had last month) in the next five months. Watching #2 son struggle with a budding family, and getting fewer hours as even the health-care business slows down. UPS is giving #1 son fewer hours than he needs. Life is always interesting with seven kids.

I can remember really struggling as a young entrepreneur in my 20s and 30s. There were many nights I couldn't sleep as I worried about payroll or a bill coming due. No one gave me a course in basic business. I had to learn it "on –the –job," as they say. It wasn't always pretty. It was a struggle starting out in the '70s, but you got up every morning and did your best. It was not easy. And now, I watch my kids do the same thing. It is a struggle for them, too. It is a reminder how just lucky I am. I truly feel I am one of the most blessed of men.

Have a great week, and remember that the world will not come to an end. It is important to find the good in life and enjoy it, even in the midst of the fight. Somehow, we will all figure out how to Muddle Through together.

Your ready to find some wine analyst,

John Mauldin

Buddy, Can You Spare $5 Trillion?

John Mauldin — Sat, 11 Jul 2009 04:26:00 GMT

This Is Outrageous
The Land of the Setting Sun
Buddy, Can You Spare $5 Trillion?
New York and Maine

There is no doubt that the US is in financial trouble. Those talking of a strong recovery are just not dealing with reality. But the US is in better shape than a lot of countries. This week, we begin by looking at Japan. I have written for years about how large their debt-to-GDP ratio is, yet they keep on issuing more debt and seemingly getting away with it. But now, several factors are conspiring to create real problems for the Land of the Rising Sun. They may soon run into a very serious-sized wall. And it is not just Japan. Where will the world find $5 trillion to finance government debt? We look at some very worrisome graphs. Those in the US who think that what happens in the rest of the world doesn't matter just don't get it. There is a lot to cover in what will be a very interesting letter. I suggest removing sharp objects or pouring yourself a nice adult beverage.

This Is Outrageous

But first, I want to direct the attention of those in the US finance industry to a white paper written by Themis Trading, called "Toxic Equity Trading Order Flow on Wall Street." Basically, they outline why volume and volatility have jumped so much since 2007; and it's not due to the credit crisis. They estimate that 70% of the volume in today's markets is from high-frequency program trading. They outline how large brokers and funds can buy and sell a stock for the same price and still make 0.5 cents. Do that a million times a day and the money adds up. Or maybe do it 8 billion times. It requires powerful computers, complicity of the exchanges (because the exchanges get paid a lot), and highly proximate computer connections. Literally, the need for speed is so important that to play this game you have to have your servers physically at the exchange. Across the river in New Jersey is too slow. Forget Texas or California. This is a game played out in microseconds.

The retail world doesn't get to play. This is a game only for big boys who can afford to pay for the "arms" needed to fight this war. But the rest of us pay for the game, as that half cent is like a tax on transactions, not to mention the increased daily volatility, which skews pricing. Think it doesn't affect you? That "tax" is paid by mutual funds, your pension fund, and every large institution.

Frankly, this is outrageous. The more I read the madder I got. And it is going to get worse as computers get faster and software more intelligent. We need rules to level the playing field. Themis suggests one simple one: just make it a rule that all bids have to be good for at least one second. That would cure a lot of problems. One lousy second! In a world of microseconds, that is an eternity.

Goldman Sachs went after an employee who stole some of their latest and greatest software this last week. The US assistant attorney general said in the courtroom that the software had the potential to manipulate the market. Imagine that. I am shocked. There is gambling going on in the back room? Gee, commissioner, I had no idea.

All this "algo" (algorithmic) trading also gives a very false impression of volume. If you are a fund and see 10 million shares a day traded, you might feel comfortable that you could hold one million shares and exit your trade easily. But if 80% of the volume is false "algo" trading, that volume isn't really there. You may have a position that will be a problem if you want to exit, and not know it.

"High-frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don't even know it." (Themis Trading)

We are literally talking billions of dollars here. The SEC needs to step in and stop this, and soon. This is a lot more important than the salaries of investment professionals, for which the Obama administration today suggested new rules, which would allow the SEC to oversee salaries at member firms. Seriously? They don't have enough to do already?

The link to the white paper is http://www.themistrading.com/article_files/0000/0348/Toxic_Equity_Trading_on_Wall_Street_12-17-08.pdf. Themis Trading is at http://www.themistrading.com/.

Read the paper. Then, if you like, drop the very nice folks at the SEC your thoughts at tradingandmarkets@sec.gov. And now, let's start off with Japan.

The Land of the Setting Sun

One of the real benefits of writing this letter is that I get to see a lot of really interesting information from readers and meet with very savvy investment professionals. This week I had the privilege of sitting with a team of analysts from Hayman Capital here in Dallas. Hayman runs a global macro hedge fund, so they spend a lot of time thinking about how all the different aspects of the global markets fit together.

A one-hour meeting stretched to three hours, as the discussion was quite lively. I learned a lot more than I contributed (which is not unusual). After I made my presentation, they showed me a presentation they had been using. Some of the graphs were quite eye-opening. While I had seen some of the data in different places, there were a lot of new ideas, and having it all in one place was extremely helpful. There was a lot of work (as in months) done here; and Kyle Bass, the founder of the firm, graciously allowed me to share some of it with you (and kudos to Wes Swank, who pulled this together). The graphs are theirs, and my discussion about them is certainly informed by our meeting; but I am using the material as a launching point, so they are not responsible for my conclusions and interpretations.

Over the years, I have written about Japan often. Its economy is very important to the world, and its banks have funded and loaned a great deal to companies outside of Japan. Global growth would have been a lot slower without the Japanese. Up until recently, their population has saved a great deal of its disposable income, and those savings have allowed the Japanese government to run massive deficits.

And we are talking truly massive. Over the last ten years, the government has seen the level of debt-to-GDP rise from 99% to over 170%, not including local governments. They ran those deficits to try and pull themselves out of the doldrums of their Lost Decade of the '90s, following the crash of their real estate and stock markets, starting in 1989. They built bridges and roads to nowhere, all sorts of programs, quantitative easing, etc. Sound familiar?

Of course, they were coming out of two really large bubbles, far larger than those recently in the US. I think I remember reading that at one point the land on which the Imperial Palace in Tokyo is built was valued at more than all of the real estate in California. Why not buy Pebble Beach or a few iconic buildings in New York, when they were so cheap? Today, Japanese real estate is still massively down (on the order of 50-80%, depending on location). And the Nikkei is still down roughly 75%, 20 years later. Do you think the Dow will be at 3,500 in 12 years?

As late as 1999, personal savings plus pensions were running at 12% and had been as high as 16%. And much of those savings went into government debt. The government kept borrowing, and rates stayed in the area of 1%. Today, a ten-year bond yields 1.3% in Japan, so they could run up a very large debt and the interest-rate cost was not a big factor in the budget.

But now things are changing. Demography is starting to change the landscape. Japan is a rapidly aging nation. The population is shrinking, and the birth rate is among the lowest in the world. And the dependency ratio is starting to rise. There are currently 1.2 nonproductive citizens (under 15 years old and over 64) for every productive Japanese; the ratio will reach 2.0 by 2020 and will continue to grow thereafter. (See chart below.)

This also means that the ability to save is dropping, since so many retirees now need to dip into savings to live. Notice in the chart below that savings have dropped from 18% to 1.8%. Also notice that annual net savings is now down to 5 trillion yen.

But this year, the Japanese will want to issue roughly 33 trillion yen in debt! Also note that the national pension fund has informed the government that this year they will for the first time be net sellers of debt. Look at the chart below. Notice that as debt was increasing through 2006, actual interest-rate expense for government debt was decreasing, because rates were dropping, getting to 0.1% in 2001. Yet with no more room to cut rates, interest-rate expenses have started to rise. Total government debt is now close to 900 trillion yen.

Interest-rate expense is now about 18% of the Japanese government budget. What if rates went to a lofty 2%? That would over time double the interest-rate expense. And the Japanese are borrowing between 30-40% of their annual budget. The total debt is rising rapidly.

Ok, let's go over these points:

Japan's population is shrinking, and the number of workers per retiree is rising. Japan has the highest ratio of debt to GDP in the developed world. And that debt is growing by 7-8% a year, and does not include local debt. Interest rates cannot go lower. Savings are falling rapidly and will not be able to cover the need for new debt issuance, by a long shot. Within a few years, because of the aging of the population, savings will go negative. Social security payments are rising. GDP is shrinking, and export trade is off about 30-40%, depending on the industry. Machine tools are down 80%!

If rates were to go up by 1%, let alone 2%, over time Japan's percentage of tax revenue dedicated to interest payments would double to 18% and then to 40% and then just keep going up. It is conceivable that it will take 100% of tax revenues in less than ten years, at the current trajectory. Why? Because Japan is going to have to start to compete with the rest of the world to sell its bonds. Who but the Japanese would buy a Japanese bond at 1.3%? From a country that is rapidly going to 200% of debt-to-GDP? Doesn't really seem like a smart trade to me. And as the data shows, the ability of the Japanese consumer to buy more debt is rapidly waning.

The Japanese government is coming to a crossroads with no good exits. Cut the budget drastically in the face of a deflationary recession? Monetize the debt and let the yen go the way of all fiat currencies? Can someone say Zimbabwe? Increase already high taxes in a very weak economy?

And yet the yen has been getting stronger over the last month. It is now at 92 to the dollar, up from 120 just two years ago. Why would a country with such bad fundamentals have such a strong currency? Shouldn't the yen be a screaming short?

Let me offer two speculations that are mine alone. First, it is well-known that the Japanese are very involved in the reverse carry trade. That is, since they can't find yield in Japan, they convert to another higher-yielding currency for income. So, maybe the retirees actually need to spend some of that money they have outside of Japan to live, so they have to convert to yen.

Second, Japanese corporations are getting hammered. Could it be that they are bringing yen home to pay for current transactions like rent and payroll? Japanese corporations dependent on exports desperately need the yen to fall, yet the central bank can't seem to engineer a falling yen. I wrote about five years ago that the Japanese Central Bank has to rank as one of the most incompetent of all central banks, because they can't even destroy their own currency.

But I think the central bank is going to figure it out. If they do not monetize the debt, rates will have to rise over time (say the next 2-3 years), and that is most definitely a problem. Monetizing the debt would mean the yen would fall in value, which is something they actually want to happen. How much monetization? When? I don't know, and I doubt they do. If I were the head of the central bank or the government, I would not sleep easy.

Japan is the second largest economy in the world. There is a rule in economics: "If something can't continue, then it won't." Japan can't continue down this path. All the trends are going against them. Sadly, Japan is going to hit the wall, maybe some time in the next few years. This will be very bad for the world, as they have financed much of Asian growth. They do in fact buy a lot of world goods, and their buying power is going to fall. This is going to mean fewer US and European jobs. Not to mention fewer jobs in the countries that are Japan's neighbors.

And unless we change things in the US, this will be us in less than ten years. As in hit the wall, serious depression, etc. I am hopeful that we can actually get our act together. But then I am an eternal optimist.

Buddy, Can You Spare $5 Trillion?

I have been writing for months that I don't think the US can find $2 trillion dollars this year and then come back to the well for another $1.5 trillion next year without serious disruption in the markets. Where do you find that much money when all the rest of the world also wants to borrow massive amounts? How much are we talking about? The friendly folks at Hayman actually spent the time to add it all up. This is not a comforting graph.

The graph shows the US will need to issue $3 trillion in debt. "Wait," I asked, "I thought it was only 1.85" The answer is that the number has grown to almost $2 trillion (as I wrote it would). Then you need to add in off-budget items like TARP, state and municipal debt, etc. Pretty soon it adds up to another trillion. All told, Hayman estimates that the world will need to find $5.3 trillion in NEW government financing. Never mind the needs of corporations or individuals or commercial mortgages, etc.

I am still trying to get my head around this. Let's hopefully assume that they made a mistake and it is "only" $4 trillion. Where do you find that kind of money in a global deleveraging recession?

The World Bank says that total world GDP in 2008 was $60 trillion (http://siteresources.worldbank.org/DATASTATISTICS/Resources/GDP.pdf).

That means we need to find almost 9% of world GDP to fund the new government debt. Gentle reader, this is a serious problem. And now the next chart. Remove sharp objects or take another drink.

This one is titled "The Potential Shortage of Capital to Fund Treasuries." They take into account the need for corporate borrowing, new corporate equity issuance, real estate debt, capital inflows and outflows, household savings, etc.

Bottom line? There is simply not enough available capital under current conditions to do it all. Something has to give. More household savings? More foreign investment (flight to safety, as the rest of the world looks even worse)? Reduced corporate borrowing and thus less GDP growth? Higher rates to attract more foreign and US investment?

The combinations are infinite, but none of them bode well. Increased household savings means less consumer spending. To attract more foreign investment (in the amounts that will be needed) will mean higher rates. And this is 2009. What happens in 2010? And 2011?

One trillion dollars is 7% of US GDP. And we will be running trillion-dollar deficits for a very long time.

Just a thought: Do you want to be a senator or congressman running for office next year with unemployment nearing 11% (my estimate), with all of the problems mentioned above, and with a record of having voted for the largest unfunded deficits in history? It is going to be a very interesting election cycle.

I will close here, as going into the next slides will make the letter way too long, but we will get to them next week. As a teaser, they asked me what my number-one concern was. I said Europe and European banking. Interestingly, that was also their number-one concern for "exogenous" risk. It will make a great launch for next week's letter.

New York and Maine

My travel plans keep changing. Looks like I will not get to London and the Baltics this summer. So my next trip is a quick evening in New York with Art Cashin and Ron Insana for dinner, a few business meetings, and then off to Maine with my youngest son Trey for the Shadow Fed fishing weekend hosted by David Kotok at Grand Lake Streams. Talking with friends who are lucky enough to get an invite, we all say it is the highlight of our year. Just thinking about it gives me a smile. It looks like Steve Liesman of CNBC (who, by the way, is a very accomplished guitar player) will be doing a documentary of the weekend.

All in all, it is a pretty high-powered group, economics -wise, and I am looking forward to the debates, with several Fed economists and the likes of Paul McCulley, Martin Barnes, Barry Ritholtz, John Silvia (and congrats to him on his new post as chief economist for Wells Fargo), Chris Whalen, George Friedman of Stratfor, and too many others to mention. Way too much wine and great food, and the fishing is always good. It doesn't get much better.

And then I come back and get ready for daughter Amanda's wedding in Tulsa and Trey going back to school. And I turn 60 the first week of October. Oddly, my fall travel schedule is rather light, which is good, as I am so far behind on so many projects. But I do need to get to Europe and also go to Uruguay to meet with new Latin American partner Enrique Fynn (more on that in a few weeks). And two more grandkids will appear this year. Life is good and more interesting than ever.

Have a great weekend. I know mine will be fun.

Your still believing we will all get through this mess analyst,

John Mauldin

The End of the Recession?

John Mauldin — Sat, 27 Jun 2009 02:55:59 GMT

The End of the Recession?
The New Normal Is Still In Our Future
The Hidden Problem Within Unemployment Data
Was Income Really Up?
Tulsa, London, and The Baltics

Last week we began a series on data abuse, about how various commentators twist and torture data to make it say what they want, or fail to look at the details underneath the headlines. Predictably, there is a lot of fodder this week as we forge ahead into this ripe territory. The headlines screamed that US income data went up unexpectedly. Green shoots were everywhere. But if you look at the actual data, you find something much different. And, I keep hearing the insistent refrain that the market is telling us that the recovery is around the corner. Well, the recovery may be, but can the market really tell us that? I have about 25 windows open in my computer, with tons of misleading data. Let's see how much we can cover in this week's letter.

But first, I want to focus your quick attention on a new "Conversation" I will have next Monday. (For those readers who are new, I have a subscription service where I hold conversations with friends on a variety of current topics. I am gratified that it's getting rave reviews.)

I have been writing about the New Normal of late, and for my next Conversation I have invited two of the sharpest analysts I know to talk about what the New Normal will look like.

What levels do we get to? What does the world economy look like? What will the path to recovery look like? And so on! David Rosenberg, former chief economist for Merrill Lynch, one of the few mainstream analysts who got it right (now with Gluskin Sheff in Toronto) and the brilliant Michael Lewitt of Harch Capital Management, someone who was writing about the credit crisis long before it happened, are both deep thinkers, and both have strong ideas about how our future will unfold. I can't wait to get them at the same table and see if we can flesh out a few concrete ideas.

And if you subscribe today, you also can get the recently released and widely praised Conversation I did with Donald Coxe and Gary Shilling on commodities and where those markets are going. That ended up as a very powerful debate, and one from which listeners said they really came away with meaty ideas.

You can subscribe now at $109 (using code JM75), before we raise the price when we add a new quarterly Conversation service with good friend and head of Stratfor, George Friedman. He gets back from Australia this week, and we will schedule a meeting soon!

And now to funny-looking data. Where to begin? There are so many targets of opportunity!

The End of the Recession?

I walked into the office yesterday evening and there was someone on CNBC talking about how the 50-day moving average of the S&P 500 rising above the 200-day moving average was telling us the market was getting ready to rise and the recovery had started. I listened to his babbling for another 2-3 minutes and couldn't take it anymore (and no, it was not my friend Larry Kudlow, who is a lot more balanced than whoever was on.)

We keep getting told that the market is telling us "something," usually that the recession is going to end. For some reason, people keep repeating the bromide that the market looks out about 6 months. To that I politely say, rubbish.

Riddle me this, Batman. Did the market see the recession in October of 2007? We were already in recession and the S&P 500 (see below) was making new highs! Where was the market prescience? Did it see the 25%+ drop in January of this year? And I could go back and cite scores of examples where the market "missed" the future turning points over the past ten decades.

What about the shibboleth that the market turns up 6 months before the end of a recession? Sometimes that is true. But does it mean anything? The same people who said it meant something last December and January are saying it means something now. But now it's June and the recovery is not here, so maybe the market wasn't telling us something in January after all.

Gentle reader, there will be a recovery. We will talk about what kind in a few pages, if we have the time. And it is (statistically speaking) likely that the markets will have turned up before the actual recovery. But does that mean anything today?

Go back to the chart above. Notice that in 2003, when the market finally turned up, we were already well out of recession. And the market had a very quick 12% or so drop while we were in recovery, while later we went on to a 90% run-up! Was the drop telling us anything, or do we explain it away?

"In the short run," St. Graham said, "the market is a voting machine. In the long run it is a weighing machine." The voting is based on current sentiment, but what the market weighs in the long run is earnings. The market tries to forecast future income streams. And it gets it wrong as often as it gets it right.

Let's look at this yet another way. This is an important concept, and it should be a component of your economic BS detector. The CNBC host talked in breathless terms about the importance of the 50-day average moving above the 200-day average. It means nothing until it means something, and we won't know what that something is for some time.

Earlier this week (Monday, I think) the 50-day average moved BELOW the 200-day average. The analysts at Bespoke Investment Group noted:

"Going back to 1928, this is the 25th time that the S&P 500 has declined through both of these levels on the same day. On page two we have provided a table showing each of these occurrences as well as the index's returns going forward. Based on those prior instances, the S&P 500's returns going forward have been notably negative. While the S&P 500 has averaged positive returns over the next week, average returns have been negative over the next month, three months, and six months." (emphasis mine)

But 33% of the time, the markets were up six months later, often by quite a bit. And sometimes down quite a bit, but on average only slightly. Which means that as a forward-looking indicator it is interesting but not anything I would put my money (or client money) on!

(I saw some reports that differed, selecting fewer such data points and suggesting that market returns were up after such an event. Logically, that can't be. Let's be generous and just assume sloppy research.)

Before major market moves down, the 50-day average will always move below the 200 average. And the reverse is also true. It is not a sign. It is just what statistically MUST happen. And sometimes they reverse themselves, and sometimes they don't. We have no way on God's green earth of knowing whether the two moves (both up and down) this week will be bullish or bearish six months from now, based simply on the moving averages crossing. You can make the data say anything you want, but you are still just guessing.

Sidebar note: Trend Following 101. I spend a lot of time analyzing trend-following money managers of one kind or another. Basically, they look at data and try to spot trends and then invest in them. A trader who is right 70% of the time is amazing and very rare. 50% is more like it for successful traders. But they have sharp risk controls that cut their losing trades and let their winning trades "ride." Being right 50% of the time can be profitable over time. (Being right 50% of the time is harder than it looks!)

But in the media you get these "analysts" who talk a good game, acting as if a 50-70% probability is something meaningful. "The market has turned. The recession is over." And they say that when we have the first balance-sheet recession in 70 years, yet they want to compare garden-variety recessions to what we have now. Again, we can only know which of the moves (above and below the 200-day moving average) will be the real "indicator" in six months. It is only an indicator today to the extent that we can drive our cars forward looking in the rear-view mirror.

The New Normal Is Still In Our Future

Now let's take that principle a little further. Last week I detailed how air, trucking, and rail shipping is down 20% year-over-year. Global trade is down about 30% in the major exporting countries (see below).

World trade shrinks : Chart 1: Year-over-year change in total exports from 15 major exporting
countries (1991-02/2009) / Chart 2: Year-over-year change in exports from 15 major exporters
between February 2008 and February 2009 (size of circles reflects volume of exports in 2008)

End of the world? Do we just keep falling? No. At some point, six months or a year from now, the year-over-year comparisons become easier. If you are at 100 and fall to 80, then a year later you are at 88 and voila! you have a 10% increase! And the perma-bulls will be talking it up. The fact that you are still down 12% from the peak is ignored.

The point is that we have fallen quite a bit in a lot of major categories. There is really only so much you can fall. And then when you reach that new lower level of the New Normal, you begin to rise. At some point, we will be on the path to "recovery." That does not mean that we will be back to the halcyon days of mid-2007 within a year. It just means that we have stopped falling and now have to adjust to the levels of the New Normal.

The Hidden Problem Within Unemployment Data

This is going to be most evident and painful in the unemployment numbers. Last month saw the number of unemployed rise by 345,000. What was not in the headline data was that 217,000 of those jobs were estimated from the "birth-death" ratio. The US economy creates new businesses that do not get counted in the data, so the BLS estimates what that number is, using previous data patterns. When the economy turns, it overestimates new jobs in recessions and underestimates them in recoveries. No conspiracy, it is just the best methodology we currently have.

But does anyone really think 200,000 jobs were created last month? The real number of lost jobs is worse than the headline. And next month the birth-death number will likely be over 200,000 again. Add another 100,000 or so to the headline number to get closer to reality,

Again, analysts talked about a turnaround because job losses were "just" 345,000. That is a higher number than any month in the 2001-02 recession, and larger than the month after 9/11. That is a green shoot? Yes, we will see the monthly unemployment numbers fall, but they are falling from historic highs. And based on some research by the San Francisco Federal Reserve, it is likely that we will see still higher unemployment that will persist for a while longer.

Let me quote and summarize through the research at http://www.frbsf.org/publications/economics/letter/2009/el2009-18.html. (It is not long, and worth reading.)

"Our analysis generally supports projections that labor market weakness will persist, but our findings offer a basis for even greater pessimism about the outlook for the labor market. Specifically, we suggest that the relatively low level of temporary layoffs and high level of involuntary part-time workers make a jobless recovery similar to the one experienced in 1992 a plausible scenario."

Essentially, there are always workers moving into and out of employment. What they note is that the patterns seem to be changing. In the '70s and '80s, job losses were quick and deep, but the recovery was also quick. In the last two recessions, job recovery was noticeably slower, giving rise to the term "jobless recovery." It was the lack of hiring, and not firing, that was responsible for the slow employment recovery. MY thought is that before 1990 many of the job losses in recessions were from manufacturing. Businesses were quick to lay off and quick to rehire. We now have fewer manufacturing jobs, so the rehiring process has been much slower in recent recessions.

"The long and gradual return to pre-recession unemployment levels implied by the Blue Chip consensus forecast is consistent with a labor market recovery that is slightly weaker than that experienced in 1983 and slightly stronger than that experienced in 1992. However, should labor market conditions instead proceed along the path taken in the 1992 recovery, the unemployment rate could peak close to 11% in mid-2010 and remain above 9% through the end of 2011."

That is not in any Congressional budget forecast. Want to run an election campaign at 10% unemployment levels?

"... What does all this mean for the course of the labor market? We combine data on involuntary part-time workers with the standard unemployment rate to arrive at an alternative measure of labor underutilization. We plot this measure in Figure 3, which shows that the labor market has considerably more slack than the official unemployment rate indicates. The figure extends this labor underutilization measure using the Blue Chip consensus forecast for the unemployment rate as a benchmark and then adding a share of involuntary part-time workers based on the proportion of workers in that category to the unemployed during the current recession. This projection indicates that the level of labor market slack would be higher by the end of 2009 than experienced at any other time in the post-World War II period, implying a longer and slower recovery path for the unemployment rate. This suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing workforces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates." (emphasis mine)

Was Income Really Up?

Now, let's turn our attention to today's headline. Income is surprisingly up. That has to be a green shoot, right? Well, not if you look at the underlying data.

Personal income from wages and salaries was down $12 billion in May. So how did income go up? A large increase in "government social benefits" and a decline in personal taxes accounted for all the gain, and then some. The increase was the effect from the recent stimulus package, which is (for now) temporary, and not the result of a recovering economy. Hardly green shoots. It is just borrowed money from another (government) source. In principle, it is not much different than home equity withdrawal, except that taxpayers are on the hook.

And those government subsidies are going to increase. Look at the graph below. What it shows is that the average duration of unemployment is at a 60-year high, and rising. It is now at 22.5 weeks. Unemployment benefits stop at 39 weeks, temporarily up from 26 weeks. More and more people each week are thrown into very dire circumstances when they fail to find jobs and lose the benefits. Care to wager whether, when Congress comes back from vacation, the time people are allowed to be on unemployment will be increased?

And speaking of the increase in government payments to individuals, what did they do with them? In aggregate, what is happening to this stimulus? The data came out today, and I must admit I was surprised. I have been writing for years that American consumers would start to save in this recession, but I (and nearly every credible observer I read) thought that we would see a more gradual rate of increase in the savings rate. The increase in savings has been nothing short of remarkable. (See graph below.)

From a negative 3% in late 2005 (the result of massive borrowing, primarily mortgage equity withdrawal and credit cards), we have risen to a positive 6.9%. That is the highest rate since 1993. The savings rate was less than 1% last August. And totals savings (on an annualized basis) was $608 billion in April, rising to $768 billion in May. That is a 30% month-over-month increase! Maybe the American consumer has found a new religion!

But, there is more than just a new savings fervor at work. Spending rose more than disposable income, so without that increased level of government transfer payments, it is unlikely that savings would have risen as much. Before we get too giddy about savings going through the roof, we need to wait a few months to see if this was the result of new savings religion or government transfer payments (stimulus), which will soon wind down

That being said, given the sharp increase in savings, it's no wonder shipping is down 20% and global trade in the exporting economies by 30%. No wonder retail sales are down, except for Wal-Mart and other lower-price venues.

Final thought for today. The Congressional Budget Office released another report this week, saying that the current deficit levels are unsustainable. They suggest that either taxes must increase by $440 billion or spending must be cut by a like amount, or some combination. If you assume some of the new health-care and other programs are enacted, the number comes closer to $700 billion.

This is not a Congress that wants to cut other parts of the budget by $700 billion. Raising taxes by $700 billion (over 4% of GDP) will dip us back into recession. Not raising taxes will result in debt that cannot be funded at anywhere close to today's rates. A recent IMF study is very sobering about the worldwide problem of growing country debt. Finding a trillion dollars in the market every year, when every other country is also trying to raise debt is simply not going to happen. It will destroy the dollar. There are few good choices in front of us, and fewer still good choices that are likely.

OK. One final suggestion for your weekend reading. Atul Gawande, writing in The New Yorker, weaves a very sobering picture of the problem of reining in health-care costs. He contrasts two Texas border cities with similar demographics, yet one spends twice as much on health care. One town has doctors who order every possible test and the other doesn't. There is no real difference in outcomes. And then compare it to other areas, and the problem facing any health-care policy becomes all too evident. Reportedly, Obama has had everyone read this, and you should too. It provides a very different angle on the problem. http://www.newyorker.com/reporting/2009/06/01/090601fa_fact_gawande?yrail

Tulsa, London, and The Baltics

Last Tuesday I went to an Eric Clapton and Steve Winwood concert. At 64, Clapton can still play the guitar as well as anyone on this planet. It is always fun to see a man at the top of his game.

I get up early tomorrow, flying with family to get to Tulsa to be at my daughter Amanda's wedding shower, and then celebrating the twins 24^th birthday tomorrow night. Amanda's wedding is August 22, right around the corner. If there is a recession going on, no one in the wedding industry seems to know. This is the second wedding in two years, and I still have two more unmarried daughters. It's a good thing the word retirement is not in my vocabulary. If we can't get the wedding budget under control, I am going to need about 600 new Conversations subscribers in July.

July 15^th I leave for London and will guest host CNBC Squawk Box from 7-9 on Friday the 17^th. Then on to Finland, St. Petersburg, and the Baltic capitals, and ending in Rome. (Why Rome? Because that is where we could get mileage tickets back to Dallas. But I might as well spend a few days.)

Then I (and my son Trey) will spend one evening and morning in New York August 5-6 before going on to Maine for the regular August fishing extravaganza with David Kotok and a rather fun crowd of economists and other ne'er-do-wells. It is a tough ticket to get, and I am glad to be invited.

There are lots of exciting things happening in my business, and we will be making announcements in the next few weeks. You have a great week.

Your going to listen to more hard blues analyst,

John Mauldin

This Time its Different*

John Mauldin — Sat, 20 Jun 2009 02:53:00 GMT

This Time It's Different*
Peter Bernstein, R.I.P.
Welcome to the New Normal
The Three Amigos
Credit Spreads - Bullish or Bearish?
ISM - Is Less Bad That Good?
Contain Your Enthusiasm
London, The Baltics, and Rome

I have often written that the four most dangerous words in the investment world are "This Time It's Different." If memory serves me, I have written several e-letters disparaging various personages who have uttered those very words, and gone one to confirm later that it wasn't different. It almost never is. And yet - and yet! - I am going to make the case over the next few weeks that it really is different this time, with only a lonely asterisk as a caveat. What prompts my probable foolishness to tempt the investing gods is the rather large amount of bad analysis based on unreasonable (dare I say lazy or surface?) readings of statistics that is coming from the mainstream investment media and investment types with their built-in bias for bullish analysis. Normally, gentle reader, your humble analyst is a paragon of moderate sensibilities, but I have been pushed over a mental edge and need to restore balance. I anticipate that this topic will take several weeks, as trying to cover it all in one sitting would exhaust us both. It should be fun. But first...

Peter Bernstein, R.I.P.

Sadly, Peter Bernstein passed away at 90 years young on June 5. One of the great honors and privileges of my life has been getting to know Peter and his lovely wife, Barbara. Introduced at a small dinner five years ago, I have been privileged to share many dinners and meetings with him in the years since, soaking up his wisdom. Only a month ago, he made a presentation (by satellite) to Rob Arnott's annual conference and was at the top of his intellectual game. His writing of late has been some of his best. Peter cofounded the Journal of Portfolio Management and truly was the dean of investment analysts.

He wrote 10 books (five after the age of 75!). I am often asked what books I would recommend for insight into the economic world. At the very top of my list has always been Against the Gods: the Remarkable Story of Risk. If you have not read it, then get it and put it on top of your summer list. Capital Ideas is also brilliant. The Power of Gold is a must-read. You can get all three in a set at Amazon.

Jason Zweig wrote a very moving obituary in the Journal and reminded me of a few quotes I've heard from Peter. "'What we like to consider as our wealth has a far more evanescent and transitory character than most of us are ready to admit.' He urged investors to regard their gains as a kind of loan that the lender - the financial market - could yank back at any time without any notice.

"Asked in 2004 to name the most important lesson he had to unlearn, he said, 'That I knew what the future held, that you can figure this thing out. I've become increasingly humble about it over time and comfortable with that. You have to understand that being wrong is part of the investment process.'"

Peter and I chatted several times during the last year, and he continued to tell me that those who thought we were in for a typical recovery were probably going to be wrong. In private conversations he was very worried about the world, and added much wisdom to those of us privileged to sit at his feet.

Isaac Newton once said, "If I have seen further it is only by standing on the shoulders of giants." In the world of investment wisdom, there is no shoulder higher than that of Peter Bernstein. Rest in gentle peace, my friend. You will be greatly missed.

This Time It's Different*

Ben Bernanke's career will be analyzed and written about for many years. But the one thing that has caused me the most pain is his bringing of the term "green shoots" into the investment lexicon. These may be the two most overused and annoying words of my investment career. Every possible sign of a recovery is anointed with the phrase.

Of late, there has been a tendency for analysts to see numbers or statistics that are "less bad" and interpret them as signs that we are in recovery or at least almost there. They glance back at previous recoveries and say, "Doesn't this look like the last time? When such and such happens it means that recovery is on the way. We should therefore buy stocks" (or whatever).

That we are condemned to read such musings is part of the investment landscape. But that does not mean we shouldn't take the time to look at what the writer of those words is actually looking at. All too often of late, I find these people grasping at straws or failing to understand the data.

My premise for uttering the heresy "This Time It's Different*" is that the fundamental nature of the economic landscape has so changed that comparisons with post-WWII recoveries is at best problematical and at worst misleading.

As we will see next week, we are on a track that looks far more like the Great Depression than the recessions of our lifetimes. To expect a normal recovery cycle, whether it is corporate profits or lending or consumer spending or capital investment or (pick a category) is just not reasonable. This is a period that is fundamentally, in so many ways, different. And the recovery (and there will be one!) will also be of a different warp and woof throughout the entire world economy.

Let me see if I can summarize my thinking before we get into the reasoning behind it.

First, we are at the end of a huge cycle of increasing private debt that ended in an overleveraged society. The process of reducing debt and unwinding leverage is going to take a rather long time. It will not be the typical one or two years and then things get back to an ever-higher normal. We are, using a phrase coined by my friend Mohammed El Erian at PIMCO, on our way to a new normal. We are hitting a massive reset button on our economic world, taking us to some new and lower level of consumer spending, leverage, etc. No one knows what the new level will be, although admittedly we are closer to it than we were a year ago.

At this new normal, we will not need as many malls or factories or stores or new-car plants or car dealerships or any number of other things to satisfy the new normal of consumer desires. As an example, and jumping ahead to a statistic for one minute, capacity utilization is now approaching 65%. Anything under 80% is anemic. Does anyone really think that businesses (in general) are going to invest more money in expanding capacity, in the face of the lowest level of production relative to potential since the 1930s?

The savings rate has shot up from zero to 6% in just a very short time. It used to be 12%. It would not be all that unusual historically for savings to go to 9% or more in a few years. That means that consumer spending will drop by 9%. Since consumer spending was 70% of GDP, that new lower level will become our new normal. And of course, due to population growth and hopefully increasing incomes, consumer spending will once again grow from whatever that new normal will be. But it is going to take some time for spending to reach the level of our productive capacity of a few years ago. We are going to have to shutter a few factories and businesses.

David Rosenberg, now with Gluskin Sheff, offers us this insight:

"What really struck us in the employment report of a few weeks ago was the fact that the only segment of the population that is gaining jobs is the 55+ age category. This group gained 224,000 net new jobs in May while the rest of the population lost 661,000. In fact, over the last year, those folks 55 and up garnered 630,000 jobs whereas the other age categories collectively lost over six million positions. This is epic." [See chart below.]

"Moreover, the number of 55 year olds and up who have two jobs or more has risen 1.1% in the last year, the only age cohort to have managed to gain any multiple jobs at all. Remarkable. These folks have seen their wealth get destroyed by two bubble-busts less than seven years apart ... the Nasdaq nest egg back in 2001 and the 5,000 square foot McMansion in 2007. Both bubbles ended in tears ... and so close together."

As we will see, the housing market is going to take at least two more years to truly recover. Looking at one month's data that shows housing starts up a few thousand as a sign of recovery in the housing market is, well, silly. Housing starts are anemic and the inventory of unsold homes is still at all-time highs (a ten-month supply) with more and more homes coming onto the market through foreclosure.

The multiple causes of the recession are not subject to a quick fix. Offering to pay someone $4,500 to trade in an old car for a new one is a rather pathetic way to try and jump-start consumer spending and the auto industry. Is it not enough that we will "invest" $50 billion in GM, while shrinking the company to a size where it will be difficult for profits to ever pay back that investment? We have to add insult to injury and borrow more money to buy cars. Care to wager whether GM will need more money within five years? (And by the way, I love my GM (Cadillac) car, and will likely buy another one at some point, so I wish them well.)

The "stimulus plan" was ill-conceived and not very stimulative. But the combination of the Fed and Treasury and massive monetary infusions has pulled us back from the brink of Armageddon. But we are not out of the woods yet. There is much heavy lifting to be done on the way to the land of the new normal.

Welcome to the New Normal

Secondly, my premise is that the recovery is going to take longer and be much less robust than any recovery since WWII. With unemployment likely to go over 10%, and with our new normal world not needing as much production of so many things, unemployment is going to stay stubbornly higher for longer than in any previous recovery. We are going to look next week at a very sobering report from the San Francisco Fed that suggests we may be for a longer than usual jobless recovery.

Thirdly, all this is going to affect corporate profits, especially for companies that depend on consumer spending. Those investors who expect corporate profits to rebound in 2010 are likely to be disappointed. (For the record, if you go to the S&P web site, analysts are projecting anywhere from a 40% to a 60% rebound in earnings for 2010 for the S&P 500. I would willingly take the "under" on that bet if I could find any takers.) I think whatever profit recovery that is built into the market at today's prices is generous. It is going to be tough to get much of a return from traditional buy-and-hold equity index investing for some time.

Fourthly, this is a global problem and primarily one in the "developed" world. I think we will find that much of Europe will be in a worse state of affairs than the US. If there are bright spots in the developed world, I tend to think they will be Canada and Australia/New Zealand. The opportunities are more likely to be in emerging markets, after they adjust to the new normal.

What this all means is that we as investors, entrepreneurs, managers, employees, and consumers need to adjust our expectations. For those of us in the US, this is complicated significantly in that we really have no idea what new level of government spending and taxation we will be faced with in 2010 and beyond. For one of the few times in my life, what the government does is likely to have a huge impact on the economy, as there is the potential for a significant shift in the very fundamental nature of government involvement in the economy. It is difficult to see what the new normal will be.

In Continental Europe, your new normal is going to be further complicated by an eroding banking crisis that is likely to put a real crimp in any recovery. China and Asia must adjust to lower US consumer spending. They have built too many factories to supply what seemed like an inexhaustible US consumer. They have to find new internal markets or face their own new normal.

All that being said, at some point, perhaps as early as the third quarter, we could see a positive number for GDP, although I think it will be later. Part of the reason that we will see some positive numbers is that year-over-year comparisons are going to get easier to make. Last summer, when inflation was close to 5% and I was writing that deflation was the real danger, oil was rising from $40 to $160 and food prices were going through the roof. Now oil is back to $70 and so we get lower year-over-year inflation numbers. Over the last two years the price of oil/energy is up, but we measure inflation on a yearly basis.

Housing construction was once about 5% of GDP. Obviously, the collapse of housing construction has had a rather negative impact on recent GDP numbers. But housing is probably close to, if not at, a bottom. Even if it dropped by another 20%, it would have far less of an impact on GDP at the much-reduced level where it is now.

It is similar with inventories. They can only drop so much, and eventually they get to the new normal and stop being a drag on the statistical GDP. We are not in an unrelenting death spiral. There is a bottom. It is like a person jumping out of an airplane. They fall rather rapidly until the parachute opens, and as they get closer to the ground they manipulate the chute to further slow the descent. But until they reach the ground, they are still falling. That is the case today. The economy is still falling, but the parachute has opened. We are going to reach the bottom at some point. We will find that new normal. We just need to adjust our activities and plans around that new destination.

I truly believe we get back to 3% GDP growth and 4% unemployment at some point in the future, but it is going to be more than a few years, especially if taxes are raised as much as is talked about in some circles. But just as in the late '70s, when the outlook was not very bright, things will change for the better. When asked back then where the new jobs would come from, the correct answer was "I don't know, but they will come."

It is the same today. There are whole new technologies and industries that are going to be created in the next decade. Entrepreneurs will respond with new innovations and businesses. Jobs that are not now on the horizon will spring up.

As a society, we are having to work through the excesses of a lifestyle that was propped up by ever-increasing debt and an out-of-control consumerism. That will happen in the fullness of time. But it WILL take time, and we need to adjust our expectations to account for that.

Over the next few weeks, I am going to drill down into the data to show why recovery will take longer and to help you withstand what will be an onslaught of out-of-control bullishness over data that is simply less bad. Let's start with a few easy targets.

The Three Amigos

In 2001, I wrote about what I called the Three Amigos that I watched to give us an indication of the direction of the economy. They were capacity utilization, high-yield bonds, and the (now-renamed) ISM numbers. Watching the direction they go gives us a good idea where the economy is headed. I have not written about them for years (as a trio), so let's revisit our old friends. We saw above that capacity utilization is still in a cliff dive. For there to be an actual recovery, we need to see capacity utilization start to climb back up. That is not currently a very positive indicator.

Credit Spreads - Bullish or Bearish?

A number of commentators have been effusive about how credit spreads have "come back in." And indeed, junk-bond yields have fallen. That is a good thing. Look at the graph below (courtesy of Tony Boehk).

Note that yields have simply come down to levels associated with recessions, and not with actual recovery. What happened last year is that junk-bond yields priced in Armageddon. Now they simply price in a recession and slow recovery. Could they improve more? Certainly. But the easy lifting is done. The direction is right. Let's see how they do the next few months. If those yields keep falling, that would be a very positive sign.

ISM - Is Less Bad That Good?

The Institute for Supply Management released their data for May, and again, commentators were enthusiastic about the increase in the manufacturing index. Green shoots and other signs and wonders were all over the media.

The ISM is a survey of manufacturers about how their businesses are doing. They are surveyed on ten criteria, like new orders, employment, inventories, backlog of orders, etc. (for the full report, you can go to http://www.ism.ws/ISMReport/MfgROB.cfm?navItemNumber=12942).

From these responses the ISM creates an index. An index number above 50 means that the manufacturing sector is growing, and below 50 means it is shrinking. At the web site above, you can get quite a bit of detail. It is quite true that we have come back from what was the lowest overall index number in 30 years. But we are simply back to the level that was the low in the previous two recessions. The ISM number is "less bad" and that is a good thing, but it is still a bad number. Yes, it is headed in the right direction. Let's look at the actual chart.

Of course, as businesses adjust to the new normal, whatever that level is, year-over-year comparisons will start to be positive. Simplistically, if a business makes 500 widgets a month and sales fall to 300, they will likely report falling production and rising inventories. Over time, inventories will finally settle out as management adjusts, and at some point inventories and production will (hopefully) start to rise. This gets reported as positive. The actual numbers may be down from the peak, but the direction of the company is once again on a positive slope.

When you look at the actual numbers comprising the release, the manufacturing part of the US economy is still contracting. Is it less bad than a few quarters ago? Yes, but it is still bad. The recent number is only slightly higher than the average for the last 12 months. We need this number to be above 50 to talk about an actual recovery in the here and now, as opposed to the future.

Contain Your Enthusiasm

Shipping containers moving into US ports rose by 2% in April, from March. That was cause for celebration in some circles. Buried way down, if mentioned at all, was the fact that compared to a year ago shipping is down 22%. And year-over-year comparisons have been worse for 22 months in a row. At some point, you get to a bottom. We find the new normal. But if the new normal is down 20%, that is a different-looking economy.

This quote came from good friend Dennis Gartman:

"'Stuff' moves by air when it is needed swiftly, but we can compare year-on-year data to get an idea of the relative weakness or strength of the economy. At the moment, the data is still very, very weak. According to the data reported out by the International Air Transport Association, after having touched just barely under $60 billion in '07 and '08, this year the IATA 'guesstimates' that only $40-$42 billion will move into the US.

"We are effectively back to the levels of '00-'04 and we are well below anything since '05. Having reached its worst year-on-year comparison back in December of last year when there was 23% air-transported cargo moving into the US from abroad, these yearly comparisons have remained about 20% lower since. Inventories of 'goods' on the nation's shelves remain high, and so long as that is true then we are going to see horrid, recessionary year-on-year comparisons in this very timely data."

Dennis also looked at rail shipments: "Since the start of this year this year, when the year-on year comparison was a relatively tepid -8%, the trend has been steadily 'from the upper left to the lower right' on the charts. By March, the year-on-year comparisons were averaging -15%. By April, -22%; by May -25%; and now, after a week or two of June, they are -26%. This is not a trend to be tampered with; this is a trend of some very real severity, and for now we fear that it is a trend rather firmly intact. Thankfully, it looks back, not forward; but if the past is prologue to the future, the future still looks rather bleak.

"Finally, there is a glimmering of hope on the rail horizon, and that is that the June figures, as they are compiled, are showing some signs of life. According to the AAR, 'freight traffic on US railroads during the week ended June 13 continued to show signs of gradual improvement ... [as] rail car loadings and intermodal were up from the previous week with carloads at their highest level in 10 weeks.'"

Welcome to the new normal. It is a quite distinctively different world than that of 2006. Global trade is off 10% and there is outright deflation in many places. We will have lots of data to look at over the next few weeks as we explore the new normal, but that is enough for today.

Oh, I almost forgot. The asterisk on "This Time It's Different*"? Human nature hasn't changed. We are still driven by fear and greed. The business cycle has not been repealed. Free-market capitalism will get us back (with a few new rules of engagement). What's different will be the nature of this recovery. All the other eternal truths will remain.

London, The Baltics, and Rome

I leave for London in mid-July and will co-host CNBC Squawkbox from 7-9 AM on Friday, July 17. Then the plan was to go to Eastern Europe. Things have changed, and now I am thinking of doing a tour through the Baltics, starting with Finland, then going down through the three Baltic nations, maybe a side trip to St. Petersburg, and then end up in Rome for a few days. That should be a fun vacation. We will see how much I can really pack in! But I do love to go to new places and meet new friends.

It is Father's Day weekend and all seven kids are in. The house is full. Tomorrow night we all go to see the new grandchild. Brunch on Sunday. The US Open at the Black. This weekend just can't hardly get any better. I may do my part to help the economy and go get the new Apple iPhone. My youngest son's phone broke, and my excuse is that I can give him mine and the new one then only "really" costs me $100. Consumer spending is not dead yet, to judge from the lines. But technology is a necessity, I keep telling myself.

Have a great weekend. I hope you enjoy yours as much as I am going to enjoy mine.

Your still missing his own dad analyst,

John Mauldin